UC-NRLF 


HOWT 


MONEY 


GEORGE  GARR      ENRY 


LIBRARY 

OF  THE 

UNIVERSITY  OF  CALIFORNIA. 


Class 


- 


HOW    TO    INVEST 
MONEY 


BY 

GEORGE    GARR    HENRY 

it 

Vice-President  Guaranty  Trust  Company  t  of  New  York 


OF  THE 

UNIVERSITY 

OF 

£4L!FOR^lt 


FUNK  &  WAGNALLS  COMPANY 

NEW  YORK  AND  LONDON 
1908 


UWtrtAl 


COPYRIGHT,  1908,  BY 

FUNK  &  WAGNALLS  COMPANY 

[Printed  in  the  United  States  of  America] 

Published  April,  1908 


CONTENTS 


PREFACE    5 

I.  GENERAL  PRINCIPLES  OF  INVEST- 
MENT          7 

II.  RAILROAD  MORTGAGE  BONDS       .     .  23 

III.  RAILROAD  EQUIPMENT  BONDS    .     .  40 

IV.  REAL-ESTATE  MORTGAGES      ...  51 
V.  INDUSTRIAL  BONDS 63 

VI.  PUBLIC-UTILITY  BONDS    ....  76 

VII.  MUNICIPAL  BONDS 91 

VIII.  STOCKS       100 

IX.  MARKET    MOVEMENTS    OF    SECU- 
RITIES                                            .  1 08 


188122 


PREFACE 

aim  of  this  book  is  to  present  in  clear 
form  the  simple  principles  of  investment, 
and  to  afford  the  reader  a  working  knowledge 
of  the  various  classes  of  securities  which  are 
available  as  investments  and  their  relative 
adaptability  to  different  needs.  The  book  is  an 
outgrowth  of  the  writer's  personal  experience 
as  an  investment  banker.  Most  of  the  matter 
which  is  presented  has  appeared  in  the  pages  of 
"System"  Magazine,  through  the  courtesy  of 
whose  editors  it  is  now  rearranged  and  consoli- 
dated for  publication  in  book  form. 

G.  G.  H. 


HOW  TO  INVEST  MONEY 


GENERAL    PRINCIPLES    OF    INVESTMENT 

WITH  the  immense  increase  in  wealth  in 
the  United  States  during  the  last  decade 
and  its  more  general  distribution,  the  problem 
of  investment  has  assumed  correspondingly 
greater  importance.  As  long  as  the  average 
business  man  was  an  habitual  borrower  of 
money  and  possest  no  private  fortune  outside 
of  his  interest  in  his  business,  he  was  not 
greatly  concerned  with  investment  problems. 
The  surplus  wealth  of  the  country  for  a  long 
time  was  in  the  hands  of  financial  institutions 
and  a  few  wealthy  capitalists.  These  men,  the 
officers  and  directors  of  banks,  savings-banks, 
and  insurance  companies,  and  the  possessors  of 
hereditary  wealth,  were  thoroughly  equipped 


8         HOW   TO    INVEST    MONEY 

by  training  and  experience  for  the  solving 
of  investment  problems  and  needed  no  help  in 
the  disposition  of  the  funds  under  their  con- 
trol. During  the  last  ten  years,  however,  these 
conditions  have  been  greatly  altered.  The 
number  of  business  men  to-day  in  possession 
of  funds  in  excess  of  their  private  wants  and 
business  requirements  is  far  greater  than  it 
was  ten  years  ago,  and  is  constantly  increas- 
ing. These  men  are  confronted  with  a  real 
investment  problem. 

While  they  have  not  always  recognized  it, 
the  problem  which  they  are  called  upon  to 
solve  is  really  twofold — it  concerns  the  safe- 
guarding of  their  private  fortune  and  the  wise 
disposition  of  their  business  surplus.  They 
have  usually  seen  the  first  part  of  this  prob- 
lem, but  not  all  have  succeeded  in  clearly  un- 
derstanding the  second.  When  the  treatment 
of  a  man's  business  surplus  is  spoken  of  as  an 
investment  problem,  it  is  meant,  of  course,  not 
his  working  capital,  which  should  be  kept  in 
liquid  form  for  immediate  needs,  but  that 
portion  of  his  surplus  which  is  set  aside  for 
emergencies.  It  is  coming  to  be  a  recognized 
principle  that  every  business  enterprise  of 


PRINCIPLES    OF    INVESTMENT     9 

whatever  kind  or  size  should  establish  a  reserve 
fund.  It  is  felt  that  the  possession  of  a  reserve 
fund  puts  the  business  upon  a  secure  founda- 
tion, adds  to  its  financial  strength  and  reputa- 
tion, and  greatly  increases  its  credit  and  bor- 
rowing capacity.  The  recognition  of  this  fact, 
combined  with  the  ability  to  set  aside  a  reserve 
fund,  has  brought  many  men  to  a  considera- 
tion of  the  best  way  in  which  to  dispose  of  it. 
It  is  obviously  a  waste  of  income  to  have  the 
surplus  in  bank-accounts ;  more  than  that,  there 
would  be  a  constant  temptation  to  use  it  and 
to  confuse  it  with  working  capital.  Its  best 
disposition  is  plainly  in  some  safe  interest-bear- 
ing security,  which  can  be  readily  sold,  so  that 
it  will  be  available  for  use  if  necessity  demands. 

Confronted  with  the  double  problem  thus 
outlined,  what  measure  of  success  has  attended 
the  average  business  man  in  its  solution  ? 

It  is  safe  to  say  that  the  average  man  has 
found  it  easier  to  make  money  than  to  take 
care  of  it.  Money-making,  for  him,  is  the  re- 
sult of  successful  activity  in  his  own  line  of 
business,  with  which  he  is  thoroughly  familiar ; 
while  the  investment  of  money  is  a  thing  apart 
from  his  business,  with  which  he  is  not  famil- 


io       HOW    TO    INVEST    MONEY 

iar,  and  of  which  he  may  have  had  little  prac- 
tical experience.  His  failure  to  invest  money 
wisely  is  not  due  to  any  want  of  intelligence 
or  of  proper  care  and  foresight  on  his  part, 
as  he  sometimes  seems  to  believe,  but  simply 
because  he  is  ignorant  of  the  principles  of  a 
business  which  differs  radically  from  his  own. 

The  investment  of  money  is  a  banker's  busi- 
ness. When  the  average  man  has  funds  to 
invest,  whether  he  be  a  business  man  or  a  pure 
investor,  he  should  consult  some  experienced 
and  reliable  investment  banker  just  as  he  would 
consult  a  doctor  or  a  lawyer  if  he  were  in  need 
of  medical  or  legal  advice.  This  book  is  not 
intended  to  take  the  place  of  consultation  with 
a  banker,  but  to  supplement  it. 

The  advantage  of  such  consultation  is  shown 
by  the  fact  that  if  a  man  attempts  to  rely  on 
his  own  judgment,  he  is  almost  certain  not  to 
do  the  best  thing,  even  if  his  business  instinct 
leads  him  to  avoid  those  enterprises  which  are 
more  plainly  unpromising  or  fraudulent.  It 
should  be  remembered,  however,  that  widows 
and  orphans  are  not  the  only  ones  ensnared 
by  attractive  advertisements  and  the  promise  of 
brilliant  returns.  In  most  cases,  widows'  and 


PRINCIPLES    OF    INVESTMENT    n 

orphans'  funds  are  protected  by  conscientious 
and  conservative  trustees,  and  it  is  the  average 
business  man  who  furnishes  the  money  which 
is  ultimately  lost  in  all  propositions  which  vio- 
late the  fundamental  laws  of  investment. 

The  average  man  is  led  into  these  unwise 
investments  through  a  very  natural  error  of 
judgment.  Accustomed  to  take  reasonable 
chances  and  to  make  large  returns  in  his  own 
business,  he  fails  to  detect  anything  fundamen- 
tally wrong  in  a  proposition  simply  because  it 
promises  to  pay  well.  He  forgets  that  the  rate 
of  interest  on  invested  money,  or  pure  interest, 
is  very  small,  and  that  anything  above  that  can 
only  come  as  payment  for  management,  as  he 
makes  in  his  own  business,  or  at  the  sacrifice 
of  some  essential  factor  of  safety  which  will 
usually  lead  to  disaster. 

For  the  successful  investment  of  money, 
however,  a  good  deal  more  is  required  than 
the  mere  ability  to  select  a  safe  security.  That 
is  only  one  phase  of  the  problem.  Scientific  in- 
vestment  demands  a  clear  understanding  of 
the  fundamental  distinctions  between  different 
classes  of  securities  and  strict  adherence  to  the 
two  cardinal  principles,  distribution  of  risk  and 


12       HOW   TO    INVEST    MONEY 

selection  of  securities  in  accordance  with  real 
requirements. 

One  of  the  most  important  distinctions  is 
that  between  promises  to  pay  and  equities. 
Bonds,  real-estate  mortgages,  and  loans  on  col- 
lateral represent  somebody's  promise  to  pay  a 
certain  sum  of  money  at  a  future  date;  and  if 
the  promise  be  good  and  the  security  ample, 
the  holder  of  the  promise  will  be  paid  the  money 
at  the  time  due.  On  the  other  hand,  equities, 
such  as  the  capital  stocks  of  banking,  railway, 
and  industrial  corporations,  represent  only  a 
certain  residuary  share  in  the  assets  and  profits 
of  a  working  concern,  after  payment  of  its 
obligations  and  fixt  charges.  The  value  of  this 
residuary  share  may  be  large  or  small,  may 
increase  or  diminish,  but  in  no  case  can  the 
holder  of  such  a  share  require  any  one,  least 
of  all  the  company  itself,  to  redeem  the  cer- 
tificate representing  his  interest  at  the  price  he 
paid  for  it,  nor  indeed  at  any  price.  If  a  man 
buys  a  $1,000  railroad  bond,  he  knows  that  the 
railroad,  if  solvent,  will  pay  him  $1,000  in  cash 
when  the  bond  is  due.  But  if  he  buys  a  share 
of  railroad  stock,  his  only  chance  of  getting  his 
money  back,  if  he  should  wish  it,  is  that  some 


PRINCIPLES    OF    INVESTMENT    13 

one  else  will  want  to  buy  his  share  for  what  he 
paid  for  it,  or  more.  In  one  case  he  has  bought 
a  promise  to  pay,  and  in  the  other  an  equity. 

It  is  not  the  intention,  from  the  foregoing, 
to  draw  the  conclusion  that  equities  under  no 
circumstances  are  to  be  regarded  as  invest- 
ments, because  many  of  our  bank  and  railroad 
stocks,  and  even  some  of  our  public-utility  and 
industrial  stocks,  have  attained  a  stability  and 
permanence  of  value  and  possess  sufficiently 
long  dividend  records  to  justify  their  considera- 
tion when  investments  are  contemplated ;  but  it 
is  essential  that  the  investor  should  have  a 
thorough  understanding  of  the  distinction 
involved. 

The  principle  of  distribution  of  risk  is  a  sim-  \/ 
pie  one.  It  involves  no  more  than  obedience 
to  the  old  rule  which  forbids  putting  all  one's 
eggs  in  the  same  basket.  The  number  of  men 
who  carry  out  this  principle  with  any  thorough- 
ness, however,  is  very  small.  Proper  distribu- 
tion means  not  only  the  division  of  property 
among  the  various  forms  of  investment,  as 
railroad  bonds,  municipals,  mortgages,  public- 
utility  bonds,  etc.,  but  also  the  preservation  of 
proper  geographical  proportions  within  each 


14       HOW    TO    INVEST    MONEY 

form.  Adherence  to  this  principle  is  perhaps 
not  so  important  for  private  investors  as  for 
institutions.  A  striking  instance  of  the  need 
for  insistence  upon  its  observance  in  the  institu- 
tional field  was  furnished  by  one  of  the  fire- 
insurance  companies  of  San  Francisco  after 
the  earthquake.  It  appeared  that  the  company's 
assets  were  largely  invested  in  San  Francisco 
real  estate  and  in  local  enterprises  generally, 
where  the  bulk  of  its  fire  risks  were  concen- 
trated. As  a  result,  the  very  catastrophe  which 
converted  its  risks  into  actual  liabilities  de- 
prived its  assets  of  all  immediate  value.  This 
instance  serves  to  show  the  importance  of  the 
principle  and  the  necessity  for  its  observance. 

The  principle  of  selection  in  accordance  with 
real  requirements  is  more  complex.  It  involves 
a  thorough  understanding  of  the  chief  points 
which  must  be  considered  in  the  selection  of 
all  investments.  These  are  five  in  number :  ( i ) 
Safety  of  principal  and  interest,  or  the  assur- 
ance of  receiving  the  principal  and  interest  on 
the  dates  due;  (2)  rate  of  income,  or  the  net 
return  which  is  realized  on  the  actual  amount 
of  money  invested;  (3)  convertibility  into  casli, 
or  the  readiness  with  which  it  is  possible  to 


PRINCIPLES    OF   INVESTMENT    15 

realize  on  the  investment;  (4)  prospect  of  ap- 
preciation in  value,  or  that  growth  in  intrinsic 
value  which  tends  to  advance  market  price ;  and 
(5)  stability  of  market  price,  or  the  likelihood  f\JL» 
of  maintaining  the  integrity  of  the  principal 
invested. 

The  five  qualities  above  enumerated  are  pres- 
ent in  different  degrees  in  every  investment, 
and  the  scientific  investor  naturally  selects 
those  securities  which  possess  in  a  high  degree 
the  qualities  upon  which  he  wishes  to  place 
emphasis.  A  large  part  of  the  problem  of  in- 
vestment lies  in  the  careful  selection  of  securi- 
ties to  meet  one's  actual  requirements.  The 
average  investor  does  not  thoroughly  under- 
stand this  point.  He  does  not  realize  that  a 
high  degree  of  one  quality  involves  a  lower 
degree  of  other  qualities.  He  may  have  a  gen- 
eral impression  that  a  high  rate  of  income  is 
apt  to  indicate  less  assurance  of  safety,  but  he 
rarely  applies  the  same  reasoning  to  other  qual- 
ities. When  he  buys  securities,  he  is  quite 
likely  to  pay  for  qualities  which  he  does  not 
need.  It  is  very  common,  for  example,  when 
he  wishes  to  make  a  permanent  investment  and 
has  no  thought  of  reselling,  to  find  him  pur- 


16       HOW    TO    INVEST    MONEY 

chasing  securities  which  possess  in  a  high  de- 
gree the  quality  of  convertibility.  From  his 
point  of  view,  this  is  pure  waste.  A  high  de- 
gree of  convertibility  is  only  obtained  at  the 
sacrifice  of  some  other  quality — usually  rate  of 
income.  If  he  were  to  use  more  care  in  his 
selections,  he  could  probably  find  some  other 
security  possessing  equal  safety,  equal  stability, 
and  equal  promise  of  appreciation  in  value, 
which  would  yield  considerably  greater  rev- 
enue, lacking  only  ready  convertibility.  Thus 
he  would  satisfy  his  real  requirements  and  ob- 
tain a  greater  income,  at  the  expense  only  of 
a  quality  which  he  does  not  need. 

The  quality  of  convertibility  divides  invest- 
ors into  classes  more  sharply  than  any  other 
quality.  For  some  investors  convertibility  is  a 
matter  of  small  importance ;  for  others  it  is  the 
paramount  consideration.  Generally  speaking, 
the  private  investor  does  not  need  to  place  much 
emphasis  upon  the  quality  of  convertibility,  at 
least  for  the  larger  part  of  his  estate.  On  the 
other  hand,  for  a  business  surplus,  ready  con- 
vertibility is  an  absolute  necessity,  and  in  order 
to  secure  it,  something  in  the  way  of  income 
must  usually  be  sacrificed. 


PRINCIPLES    OF    INVESTMENT    17 

Again,  some  investors  are  so  situated  that 
they  can  insist  strongly  upon  promise  of  appre- 
ciation in  value,  while  others  can  not  afford  to 
do  so.  Rich  men  whose  income  is  in  excess  of 
their  wants,  can  afford  to  forego  something  in 
the  way  of  yearly  return  for  the  sake  of  a 
strong  prospect  of  appreciation  in  value.  Such 
men  naturally  buy  bank  and  trust-company 
stocks,  whose  general  characteristic  is  a  small 
return  upon  the  money  invested,  but  a  strong 
likelihood  of  appreciation  in  value.  This  is  ow- 
ing to  the  general  practise  of  well-regulated 
banks  to  distribute  only  about  half  their  earn- 
ings in  dividends  and  to  credit  the  rest  to  sur- 
plus, thus  insuring  a  steady  rise  in  the  book 
value  of  the  stock.  Rich  men,  again,  can  afford  to 
take  chances  with  the  quality  of  safety,  for  the 
sake  of  greater  income,  in  a  way  which  poor 
men  should  never  do.  In  practise,  however,  if 
the  writer's  observation  can  be  depended  upon, 
it  is  usually  the  poor  men  who  take  the  chances 
— and  lose  their  money. 

In  the  quality  of  safety,  there  is  a  marked 
difference  between  safety  of  principal  and 
safety  of  interest.  With  some  investments  the 
principal  is  much  safer  than  the  interest,  and 


i8       HOW    TO    INVEST    MONEY 

vice  versa.  This  can  best  be  illustrated  by  ex- 
amples. The  bonds  of  terminal  companies, 
which  are  guaranteed  as  to  interest,  under  the 
terms  of  a  lease,  by  the  railroads  which  use 
the  terminal,  are  usually  far  safer  as  to  interest 
than  as  to  principal.  While  the  lease  lasts,  the 
interest  is  probably  perfectly  secure,  but  when 
the  lease  expires  and  the  bonds  mature,  the 
railroads  may  see  fit  to  abandon  the  terminal 
and  build  one  elsewhere,  if  the  city  has  grown 
in  another  direction,  and  the  terminal  may  cease 
to  have  any  value  except  as  real  estate.  On 
the  other  hand,  a  new  railroad,  built  in  a 
thinly  settled  but  rapidly  growing  part  of  the 
country,  may  have  difficulty  in  bad  years  in 
meeting  its  interest  charges,  and  may  even  go 
into  temporary  default,  but  if  the  bonds  are 
issued  at  a  low  rate  per  mile  and  the  manage- 
ment of  the  road  is  honest  and  capable,  the 
safety  of  the  principal  can  scarcely  be  ques- 
tioned. 

Stability  of  market  price  is  frequently  a  con- 
sideration of  great  importance.  This  quality 
should  never  be  confused  with  the  quality  of 
safety.  Safety  means  the  assurance  that  the 
maker  of  the  obligation  will  pay  principal  and 


PRINCIPLES    OF    INVESTMENT    19 

interest  when  due;  stability  of  market  price 
means  that  the  investment  shall  not  shrink  in 
quoted  value.  These  are  very  different  things, 
tho  frequently  identified  in  people's  minds.  An 
investment  may  possess  assured  safety  of  prin- 
cipal and  interest  and  yet  suffer  a  violent  de- 
cline in  quoted  price,  owing  to  a  change  in 
general  business  and  financial  conditions.  In 
times  of  continued  business  prosperity  very 
high  rates  are  demanded  for  the  use  of  money, 
because  the  liquid  capital  of  the  country,  to  a 
large  extent,  has  been  converted  into  fixt  forms, 
in  the  development  of  new  mines,  the  building 
of  new  factories  and  railroads,  and  in  the  im- 
provement and  extension  of  existing  properties. 
These  high  rates  have  the  effect  of  reducing 
the  price  level  of  investment  securities  because 
people  having  such  securities  are  apt  to  sell 
them  in  order  to  lend  the  money  so  released, 
thus  maintaining  the  parity  between  the  yields 
upon  free  and  invested  capital. 

As  an  illustration  of  this  tendency,  within 
the  last  few  years  New  York  City  3^-per-cent 
bonds  have  declined  from  no  to  90,  without 
the  slightest  suspicion  of  their  safety.  Their 
inherent  qualities  have  changed  in  no  respect 


OF  THE 

UNIVERSITY 


20       HOW   TO    INVEST    MONEY 

except  that  their  prospect  of  appreciation  in 
quoted  price  has  become  decidedly  brighter. 
Their  fall  in  price  has  been  due  to  two  factors, 
one  general  and  the  other  special — first,  the 
absorption  of  liquid  capital  and  consequent  rise 
in  interest  rates,  occasioned  by  the  unpre- 
cedented business  activity  of  the  country,  and, 
second,  to  the  unfavorable  technical  position  of 
the  bonds,  due  to  an  increased  supply  in  the 
face  of  a  decreased  demand. 

It  will  be  seen  that  the  question  of  main- 
taining the  integrity  of  the  money  invested  is 
a  matter  of  great  importance  and  deserves  to 
rank  as  a  fifth  factor  in  determining  the  selec- 
tion of  investments,  altho  it  is  not  an  inherent 
quality  of  each  investment,  but  is  depend- 
ent for  its  effect  upon  general  conditions. 
If  it  is  essential  to  the  investor  that  his  security 
should  not  shrink  in  quoted  price,  his  best  in- 
vestment is  a  real-estate  mortgage,  which  is 
not  quoted  and  consequently  does  not  fluctate. 
For  the  investment  of  a  business  surplus,  how- 
ever, where  a  high  degree  of  convertibility  is 
required,  real-estate  mortgages  will  not  an- 
swer, and  the  best  way  to  guard  against  shrink- 
age is  to  purchase  a  short-term  security,  whose 


PRINCIPLES    OF   INVESTMENT  21 

approach  to  maturity  will  maintain  the  price 
close  to  par. 

The  foregoing  comments,  in  a  brief  and  im- 
perfect way,  serve  to  indicate  the  main  points 
which  should  be  considered  in  the  selection  of 
securities  for  investment.  The  considerations 
advanced  will  be  amplified  as  occasion  demands 
in  the  following  pages.  For  the  present,  the 
main  lesson  which  it  is  sought  to  draw  is  the 
necessity  that  a  man  should  have  a  thorough 
understanding  of  his  real  requirements  before 
he  attempts  to  make  investments.  For  a  pri- 
vate investor  to  go  to  a  banker  and  ask  him  to 
suggest  a  security  to  him  without  telling  him 
the  exact  nature  of  his  wants  is  about  as  foolish 
as  it  would  be  for  a  patient  to  go  to  a  physician 
and  ask  him  to  give  him  some  medicine  with- 
out telling  him  the  symptoms  of  the  trouble 
which  he  wished  cured.  In  neither  case  can 
the  adviser  act  intelligently  unless  he  knows 
what  end  he  is  seeking  to  accomplish. 

It  is  plainly  impossible  within  the  limits  of 
a  small  volume  to  consider  the  needs  of  all 
classes  of  investors.  Special  attention  will  be 
paid  to  the  requirements  of  a  business  surplus 
and  of  the  private  investor.  In  the  field  of  pri- 


22       HOW   TO    INVEST    MONEY 

vate  investment  two  distinct  classes  can  be  rec- 
ognized— those  who  are  dependent  upon  in- 
come from  investments  and  those  who  are  not. 
Both  classes  will  be  considered.  For  the  in- 
vestment of  a  business  surplus,  safety,  convert- 
ibility, and  stability  of  price  are  the  qualities 
to  be  emphasied;  for  investors  dependent  upon 
income,  safety  and  a  high  return ;  and  for  those 
not  dependent  upon  income,  a  high  return  and 
prospect  of  appreciation  in  value.  In  the  fol- 
lowing chapters  railroad  bonds,  real-estate 
mortgages,  industrial,  public-utility,  and  mu- 
nicipal bonds  and  stocks  will  be  considered  in 
turn;  their  advantages  and  disadvantages  will 
be  analyzed  in  accordance  with  the  determin- 
ing qualities  above  enumerated,  and  their  adap- 
tability to  the  requirements  of  a  business  sur- 
plus and  of  private  investment  will  be  discust. 


II 

RAILROAD  MORTGAGE  BONDS 

A  RAILROAD  bond  is  an  obligation  of  a 
**  railroad  company  (usually  secured  by 
mortgage  upon  railroad  property)  which  runs 
for  a  certain  length  of  time  at  a  certain  rate 
of  interest.  It  is  apparent,  from  this  definition, 
that  the  price  of  a  railroad  bond,  as  distinct 
from  its  value,  is  affected  by  two  accidental 
conditions  quite  apart  from  the  five  determin- 
ing qualities  described  in  the  preceding  chapter. 
These  accidental  conditions  are  the  length  of 
time  that  the  bond  has  to  run  and  the  rate  of 
interest  that  it  bears.  To  understand  clearly 
the  influence  of  these  accidental  conditions  is  a 
matter  of  the  utmost  importance.  It  is  evident, 
for  instance,  that  a  5-per-cent  fifty-year  bond, 
based  on  a  given  security,  will  sell  at  a  widely 
different  price  from  a  3J^>-per-cent  twenty-year 
bond,  based  on  the  same  security;  yet  the  only 
difference  is  in  the  accidental  conditions  which 
are  under  the  control  of  the  board  of  directors. 

23 


24       HOW   TO    INVEST    MONEY 

In  order  to  eliminate  these  accidental  fea- 
tures from  the  situation,  it  is  customary  for 
bond-dealers  to  classify  bonds  purely  on  the 
basis  of  their  yield,  or  net  income  return.  As 
a  thorough  understanding  of  this  point  is  essen- 
tial to  an  accurate  judgment  of  bond  values, 
whether  railroad  bonds  or  otherwise,  it  must 
be  developed  in  detail,  even  at  the  risk  of  carry- 
ing the  reader  over  familiar  ground. 

If  a  bond  sells  above  par,  it  does  not  yield 
its  purchaser  a  net  return  as  great  as  the  rate 
of  interest  which  the  bond  bears,  for  two  rea- 
sons :  first,  because  the  loss  in  principal,  repre- 
sented by  the  premium  which  the  purchaser 
pays,  must  be  distributed  over  the  number  of 
years  which  the  bond  has  to  run,  and  operates 
to  reduce  the  rate  of  interest  which  the  holder 
receives ;  and,  secondly,  because  the  rate  is  paid 
only  on  the  par  value  of  the  bond  instead  of 
on  the  actual  money  invested.  Thus,  if  a  6-per- 
cent bond  with  eight  years  to  run  sells  at  1 10^4, 
it  will  yield  only  4.40  per  cent,  which  means 
that  if  the  holder  spends  more  than  $48.73 
(4.40  per  cent  of  $1,107.50)  out  of  the  $60 
which  he  receives  annually,  he  is  spending  the 
excess  out  of  principal,  and  not  out  of  income. 


RAILROAD    MORTGAGE    BONDS    25 

Conversely,  if  a  bond  sells  below  par,  it  yields 
more  than  the  rate  of  interest  which  the  bond 
bears. 

These  yields  have  been  calculated  with  the 
utmost  exactness  for  all  bonds  paying  from  2 
per  cent  to  7  per  cent  and  running  from  six 
months  to  one  hundred  years,  so  that  it  is  only 
necessary  to  turn  to  the  tables  to  discover  what 
will  be  the  net  return  upon  a  given  bond  at  a 
given  price.  This  net  return  is  generally 
known  as  the  "basis/'  and  bonds  are  spoken  of 
as  selling  upon  a  3.80  per  cent  basis  or  a  4.65 
per  cent  basis  or  whatever  the  figure  may  be, 
with  no  reference  whatever  to  the  price  or  to 
the  rate  of  interest  which  the  bond  bears.  In- 
deed, so  exclusively  is  the  basis  considered  by 
bond-dealers  that  very  often  bonds  are  bought 
and  sold  upon  a  basis  price,  and  the  actual 
figures  at  which  the  bonds  change  hands  are 
not  determined  until  after  the  transaction  is 
concluded. 

It  is  not  expected,  of  course,  that  the  average 
business  man  will  purchase  bonds  in  quite  as 
scientific  a  way  as  this,  but  it  is  essential  that 
he  should  understand  that  while  the  intrinsic 
value  of  a  bond  is  determined  only  by  the  five 


26       HOW   TO    INVEST    MONEY 

general  factors  described,  its  money  value,  or 
price,  is  affected  also  by  these  two  accidental 
conditions.  Exprest  in  other  words,  he  must 
realize  that  the  general  factor  described  as 
rate  of  income  does  not  mean  the  coupon  rate 
of  interest  which  the  bond  bears,  but  the  scien- 
tific "basis,"  derived  by  elimination  of  the  acci- 
dental features. 

Within  the  past  year  there  has  been  a 
good  deal  of  uninformed  comment  about  the 
safety  of  railroad  bonds.  Before  the  era  of 
popular  agitation  and  governmental  antagon- 
ism, railroad  bonds  enjoyed  a  large  measure  of 
public  confidence ;  but  it  can  not  be  denied  that 
some  part  of  this  confidence  has  been  shaken 
as  a  result  of  the  recent  exposures.  Even  clear- 
headed men  have  exaggerated  the  importance 
of  the  developments ;  and  too  often  railroad  offi- 
cials, who  should  have  insisted  upon  the  sound- 
ness and  stability  of  their  properties,  when 
they  elected  to  talk  for  publication,  have  given 
way  instead  to  dismal  and  unwarranted  fore- 
bodings. 

There  is  no  mystery  involved  in  determining 
the  safety  of  railroad  bonds.  Any  man  of  busi- 
ness experience,  keeping  in  mind  the  general 


RAILROAD    MORTGAGE   BONDS    27 

principle  which  measures  the  value  of  all  obli- 
gations, can  easily  determine,  with  the  aid  of 
two  documents,  the  degree  of  safety  which  at- 
taches to  any  particular  railroad  bond.  The 
general  principle  to  be  observed  is  that  the 
safety  of  any  obligation  depends  upon  the  mar- 
gin of  security  in  excess  of  the  amount  of  the 
loan;  and  the  two  documents  to  be  consulted 
are  the  mortgage  or  trust  indenture  securing 
the  bonds,  which  describes  the  property  mort- 
gaged, and  the  last  annual  report  of  the  rail- 
road, which  shows  its  financial  condition. 

Confining  the  analysis,  for  the  present,  to 
mortgage  bonds  upon  the  general  mileage  of 
a  railroad,  the  following  points  should  be  con- 
sidered : 

(i)  Rate  per  mile  at  which  the  bond  is 
issued.  Applying  the  general  principle  indi- 
cated above,  it  must  be  learned  what  propor- 
tion the  bonded  debt  of  a  railroad  bears  to  the 
total  market  value  of  the  property.  It  is  much 
easier  to  make  this  comparison  on  a  per-mile 
basis.  In  determining  whether  the  rate  per 
mile  is  excessive,  reference  must  be  made  not 
so  much  to  the  particular  bond  in  question  as 
to  the  total  bonded  debt  per  mile  of  the  rail- 


28       HOW   TO    INVEST    MONEY 

road,  and  to  the  relation  which  that  figure  bears 
to  the  total  market  value  of  the  property  per 
mile.  The  total  market  value  per  mile  is  ob- 
tained by  adding  the  market  value  of  the  stock 
per  mile  to  the  par  value  of  the  bonded  debt 
per  mile.  A  single  issue  of  bonds  varies  all  the 
way  from  $5,000  to  $100,000  per  mile,  accord- 
ing to  the  location  of  the  railroad.  Total  capi- 
talization per  mile — stocks  and  bonds  at  par- 
varies  in  about  the  same  proportion,  from  $35,- 
ooo  to  $300,000.  The  average  for  all  the  rail- 
roads of  the  United  States  is  $67,936  per  mile. 
The  actual  cost  of  the  railroad,  as  shown  by  the 
balance-sheet,  must  be  taken  into  consideration, 
and  also  the  estimated  cost  of  duplicating  the 
property.  Physical  difficulties  of  construction 
must  be  weighed,  for  a  railroad  through  a  flat, 
sandy  country  should  not  be  bonded  for  as 
much,  other  things  being  equal,  as  a  railroad 
through  a  mountainous  country,  where  much 
cutting,  filling,  and  bridging  are  required.  The 
section  of  country  in  which  the  railroad  is 
located  must  be  considered,  for  $35,000  per 
mile  on  a  single-track  line  in  a  poor  country 
may  be  higher  than  $300,000  per  mile  on  a 
four-track  trunk  line  which  owns  valuable  ter- 


RAILROAD    MORTGAGE    BONDS     29 

minals  and  rights  of  way  through  several  large 
cities. 

(2)  Amount  of  prior  lien  bonds  outstanding 
per  mile.     The  amount  of  bonds  which  come 
ahead  of  the  bond  in  question  on  the  same 
mileage  is  a  matter  of  great  importance  and 
works  directly  against  the  security  of  the  bond. 
Purchasing  a  bond  which  is  preceded  by  a 
prior  line  bond  is  like  taking  a  real-estate  mort- 
gage on  property  already  encumbered.    If  the 
bond  is  not  followed  by  other  bonds,  then  the 
margin  of  security  in  the  property  is  repre- 
sented wholly  by  the  market  value  of  the  stock 
per  mile,  and  the  investor  must  figure  carefully 
the  value  of  this  equity. 

(3)  Amount  of  junior  lien  bonds  outstand- 
ing per  mile.  The  amount  of  bonds  which  come 
after  the  bond  in  question,  on  the  other  hand, 
works  directly  in  favor  of  the  bond,  for  it  in- 
creases the  margin  of  security.    It  shows  also 
that  other  people  have  had  sufficient  confidence 
in  the  property  to  invest  their  money  in  obliga- 
tions subject  to  the  one  in  question.     In  the 
event  of  a  receivership  this  is  often  a  matter  of 
great  importance;  for  if  a  foreclosure  sale  is 
ordered  the  junior  bondholders,  in  order  to  pro- 


30       HOW    TO    INVEST    MONEY 

tect  their  own  interest,  must  buy  in  the  property 
for  an  amount  at  least  equal  to  the  par  value  of 
the  prior  lien  bonds. 

The  foregoing  considerations  apply  particu- 
larly to  the  safety  of  the  principal  invested  in 
railroad  bonds ;  the  following  points  affect  the 
safety  of  interest : 

(4)  Gross  earnings  per  mile.  The  gross 
earnings  of  a  railroad  must  be  compared  with 
those  of  other  roads  occupying  the  same  field, 
and  the  returns  for  a  number  of  years  must  be 
examined  to  determine  whether  such  earnings 
have  increased  or  decreased.  The  position  in 
which  the  railroad  stands  for  obtaining  new 
traffic  must  be  noted.  This  is  dependent  some- 
what upon  the  railroad's  ability  to  take  traffic 
from  other  railroads,  but  more  upon  the  proba- 
ble growth  and  development  of  the  territory 
which  the  railroad  serves,  and  the  increased 
traffic  which  will  probably  be  offered.  In  this 
connection  the  rate  of  increase  in  population  in 
the  road's  territory  is  important.  The  propor- 
tion between  passenger  and  freight  earnings, 
the  diversity  and  density  of  freight  traffic,  and 
passenger  and  freight  rates  should  be  ex- 
amined. The  reputation  of  the  management 


RAILROAD    MORTGAGE    BONDS     31 

for  ability  and  integrity  should  be  considered. 
Gross  earnings  run  from  about  $3,000  to  $40,- 
ooo  per  mile  with  the  average  $10,460. 

(5)  Net  income  per  mile.  Net  income  is 
obtained  by  subtracting  from  gross  earnings 
operating  expenses  (and  sometimes  taxes)  and 
adding  to  the  net  earnings  so  obtained  what- 
ever income  from  other  sources  the  railroad 
may  derive.  This  is  a  very  important  figure. 
As  with  gross  earnings,  the  reports  should  be 
examined  to  determine  whether  net  income  is 
on  the  increase  or  the  decrease,  and  it  should 
be  compared  with  the  net  income  of  other  rail- 
roads occupying  the  same  field.  It  involves  a 
criticism  of  operating  expenses.  The  payments 
of  the  railroad  must  be  analyzed  to  determine 
whether  the  proper  sums  have  been  expended 
for  maintenance  of  way,  replenishment  of  roll- 
ing stock,  and  other  improvements  sufficient  to 
keep  the  road  in  good  physical  condition.  Nor- 
mally speaking,  operating  expenses  should  ab- 
sorb about  65  per  cent  of  gross  earnings.  If  it  is 
found  that  a  railroad  operates  for  60  per  cent, 
however,  it  does  not  always  follow  that  its  oper- 
ating officials  are  exceptionally  efficient,  so  that 
the  cost  of  conducting  transportation  is  rela- 


32       HOW    TO    INVEST    MONEY 

lively  small ;  it  may  mean  that  the  physical  con- 
dition of  the  property  is  being  neglected,  or  that 
ordinary  improvements,  which  should  be 
charged  to  maintenance,  are  being  paid  for  by 
increase  in  capitalization.  It  is  very  important 
for  the  investor  to  find  out  which  is  the  case.  If 
analysis  leads  to  the  suspicion  that  the  earnings 
result  from  neglecting  the  property  or  capital- 
izing every  trivial  improvement,  the  railroad's 
bonds  should  be  rejected.  Net  income  varies 
from  $1,500  to  $12,000  per  mile,  with  an  aver- 
age of  $4,702. 

(6)  Fixt  charges  per  mile.  The  fixt  charges 
of  a  railroad  include  interest  on  its  bonds,  rent- 
als, and  taxes  (when  the  last-named  are  not 
reported  with  operating  expenses).  The  im- 
portance of  this  figure  lies  in  its  relation  to  net 
income.  If  a  railroad  does  not  earn  well  over 
double  its  fixt  charges,  its  obligations  can  not  be 
regarded  as  in  the  first  investment  rank.  Of 
course,  when  a  railroad  earns  more  than  twice 
the  interest  requirement  upon  its  entire  bonded 
debt,  it  is  probable  that  some  of  the  underlying 
bonds  are  protected  by  three,  four,  or  five  times 
the  interest  requirement  upon  them,  and  their 
position  is  correspondingly  strengthened. 


I 

OF 
C4l   ir 


RAILROAD    MORTGAGE    BONDS    33 

The  foregoing  analysis  applies  particularly 
to  mortgage  bonds  upon  the  general  mileage  of 
a  railroad  and  not  to  such  special  issues  as  col- 
lateral trust,  terminal,  bridge,  or  guaranteed 
bonds.  It  will  not  be  necessary,  however,  to 
lay  down  any  rules  as  to  these  classes  of  bonds, 
for  the  general  principles  outlined  above,  with 
slight  modifications  of  detail,  will  be  found 
equally  applicable  to  a  judgment  of  their  value. 
Equipment  bonds,  on  the  other  hand,  owing  to 
their  want  of  similarity  to  any  other  railroad 
issues,  will  receive  separate  treatment  later. 

It  is  of  interest,  in  view  of  the  present  dimin- 
ished confidence  in  railroad  securities,  to  ad- 
vance certain  considerations  touching  upon  the 
safety  of  railroad  bonds  in  general. 

The  last  published  report  of  the  Inter-State 
Commerce  Commission,  year  1906,  furnishes 
interesting  testimony  on  this  subject.  A  table 
on  page  60  shows  that  the  total  railroad  capital 
of  the  United  States  for  that  year  was  $14,570,- 
421,478,  of  which  $7,766,661,385,  or  53.31  per 
cent,  was  in  the  form  of  bonded  debt,  and  the 
rest  in  capital  stock. 

These  figures  indicate  a  substantial  equity, 
but  are  somewhat  misleading  because  they 


34       HOW   TO    INVEST    MONEY 

refer  to  par  value.  A  fair  estimate  of  the  mar- 
ket value  of  this  stock  equity,  which  is  the  mar- 
gin of  security  in  the  properties  from  the 
bondholder's  point  of  view,  can  be  obtained 
from  a  table  on  page  82,  which  shows  a  balance 
available  for  dividends,  after  paying  all  opera- 
ting expenses  and  fixt  charges,  of  all  the  rail- 
roads of  the  United  States  for  the  year  ended 
June  30,  1906,  of  $457,060,326.  This  amount 
is  equivalent  to  nearly  7  per  cent  upon  the  total 
par  value  of  the  stocks. 

Estimating  that  a  railroad  stock  should  earn 
10  per  cent  upon  its  market  price — and  even 
the  most  prejudiced  will  admit  that  a  stock 
earning  10  per  cent  is  worth  par — the  total 
market  value  of  American  railroad  stocks 
would  be  $4,570,603,260,  or  more  than  half  the 
par  value  of  the  bonds.  In  other  words,  the 
bonded  debt  would  represent  something  less 
than  63  per  cent  of  the  total  market  value  of 
the  property.  This  compares  favorably  with 
the  security  of  first  mortgages  upon  real  estate. 

When  the  safety  of  interest  is  considered, 
the  showing  made  is  equally  strong.  Page 
82  of  the  report  above  quoted  shows  that 
the  net  income  of  the  railroads  of  the  United 


RAILROAD    MORTGAGE    BONDS    35 

States  for  the  year  ended  June  30,  1906,  after 
payment  of  all  operating  expenses,  was  $848,- 
836,771,  and  the  total  fixt  charges,  including 
interest  on  bonds,  interest  on  current  liabilities, 
and  taxes,  amounted  to  $391,776,445,  leaving  a 
balance  available  for  dividends  of  $457,060,- 
326.  It  is  apparent,  therefore,  that  the  net 
earnings  of  the  railroads  of  the  United  States, 
considered  as  one  system,  could  be  cut  in  half 
without  affecting  the  payment  of  interest  upon 
the  railroad's  obligations.  This  affords  a  large 
measure  of  protection. 

The  following  analysis  shows  that  the  actual 
market  value  of  the  railroads  is  probably 
greater  than  the  estimate  made  above. 

The  table  shows  the  percentage  of  bonded  debt  to 
total  market  value  of  some  of  the  more  important 
railroad  systems.  Two  trunk  lines  in  the  East,  a 
north  and  south  line  in  the  middle  West,  and  two 
transcontinentals  have  been  chosen.  No  attempt 
has  been  made  to  select  railroads  which  would  make 
a  favorable  showing.  Indeed  Pennsylvania,  and 
Union  Pacific,  by  reason  of  their  recent  heavy  bond 
issues,  probably  compare  unfavorably  with  others 
which  might  have  been  chosen.  The  figures  show- 
ing the  par  value  of  bonds  outstanding  have  been 
taken  from  last  annual  reports,  with  additions  made 


36       HOW   TO    INVEST   MONEY 

for  recent  issues.  The  figures  showing  the  market 
value  of  stocks  are  based  on  the  amounts  outstand- 
ing April  ist,  1908,  at  the  market  price. 

Per  cent 

Par  value  of          Approx.  market      of  bonds 

bonds  outstand-        value  of  stock          to  total 

ing  outstanding  value 

Pennsylvania    $270,974,645  $361,000,000  42.8 

New  York  Central   255,414,845  174,000,000  59.4 

Illinois  Central    1 56,053,275  120,000,000  56.6 

Great   Northern   207,5 17,,939  260,000,000  44.3 

Union    Pacific    274,827,000  324,000,000  45.9 

In  view  of  the  enormous  decline  which  has 
occurred  in  railroad  stocks  during  the  past 
eighteen  months,  the  showing  above  is  truly  re- 
markable. It  is  plain  that  the  entire  bonded 
debt  of  any  of  these  standard  railroads  is  less 
than  60  per  cent  of  the  total  market  value  of  the 
property,  while  in  the  cases  of  the  Pennsylvania, 
Great  Northern,  and  Union  Pacific,  more  than 
half  of  the  present  market  value  of  the  property 
could  be  erased  before  the  lien  of  the  bonds  least 
well  secured  ivould  be  impaired. 

Of  course,  where  the  entire  bonded  debt  is 
protected  by  such  a  margin,  it  is  evident  that 
the  underlying  bonds  (the  prior  liens  and  first 
mortgages)  are  protected  by  several  times  as 
great  a  margin  and  their  position  is  corre- 
spondingly strengthened. 

The  foregoing  analysis,  in  the  judgment  of 


RAILROAD    MORTGAGE    BONDS    37 

the  writer,  affords  convincing  proof  not  only 
that  the  prevailing  want  of  confidence  in  rail- 
road obligations  is  without  foundation,  but  that 
railroad  bonds  compare  favorably  in  point  of 
safety  with  any  other  form  of  investment. 

It  remains  to  point  out  the  amount  of  income 
and  degree  of  convertibility  which  they  afford 
and  the  extent  of  appreciation  in  value  which 
they  promise.  It  is  impossible  to  do  more  than 
indicate  the  general  characteristics  of  railroad 
bonds  in  these  particulars. 

Railroad  bonds  cover  a  wide  range  of  income 
return.  They  yield  all  the  way  from  3%  per 
cent  to  9  per  cent,  the  general  average  being 
from  4  per  cent  to  6  per  cent.  As  a  class  they 
yield  more  than  government  or  municipal 
bonds,  and  less  than  public-utility  or  industrial 
bonds.  With  equal  security  they  probably  yield 
less  than  real-estate  mortgages.  Compared 
with  stocks  they  return  more  than  bank  stocks, 
average  about  the  same  as  railroad  stocks,  and 
yield  less  than  public-utility,  industrial,  or  mi- 
ning stocks.  These  comparisons  are  intended  to 
apply  to  the  classes  as  a  whole,  and  remain  gen- 
erally true  in  spite  of  specific  cases  to  the  con- 
trary. 


38       HOW   TO    INVEST    MONEY 

Convertibility  is  the  distinguishing  mark  of 
railroad  bonds.  Generally  speaking  they  may 
be  more  easily  marketed  than  any  other  class  of 
bonds.  Compared  with  stocks  they  exceed  pub- 
lic-utility, mining,  and  bank  stocks  in  point  of 
convertibility,  and  yield  only  to  railroad  stocks. 
It  is  hard  to  say  whether  or  not  they  possess 
greater  convertibility  than  industrial  stocks, 
but  it  is  probable  that  they  do,  allowing  for  the 
fact  that  an  undue  impression  is  created  by  the 
activity  of  certain  prominent  shares. 

Railroad  bonds  as  a  class  possess  great 
promise  of  appreciation  in  value.  American 
railroads,  generally  speaking,  have  adopted  the 
conservative  policy  of  putting  a  considerable 
part  of  their  annual  earnings  back  into  the 
property  in  the  form  of  improvements.  To  the 
extent  to  which  this  policy  is  followed,  an  equity 
is  created  back  of  the  bonds  which  raises  their 
intrinsic  value.  This  policy  contrasts  favor- 
ably with  the  general  practise  of  English  roads 
to  pay  out  all  their  earnings  in  dividends,  and 
to  capitalize  their  improvements.  In  addition, 
new  capital  for  American  railroads  is  largely 
raised  by  stock  issues,  which  further  increases 
the  margin  of  security  for  the  bondholders. 


RAILROAD    MORTGAGE    BONDS     39 

Taken  together  these  facts  insure  a  steady  en- 
hancement in  the  intrinsic  value  of  railroad 
bonds,  which  is  bound  to  be  reflected,  other 
things  being  equal,  in  higher  prices. 

We  shall  not  attempt  to  discuss  at  this  time 
the  degree  of  stability  of  market  price  which 
railroad  bonds  enjoy.  As  explained  in  the  first 
chapter,.  Stability  of  market  price  is  dependent 
upon  general  financial  and  business  conditions. 
It  is  sufficient  to  point  out  here  that  the  main- 
tenance intact  of  the  principal  sum  invested  can 
only  be  rendered  certain  by  the  purchase  of 
short-time  securities  whose  near  approach  to 
maturity  will  keep  their  price  close  to  par.  In 
a  later  chapter  the  general  principles  which  de- 
termine this  question  will  be  elucidated. 

The  ideal  investment  may  be  defined  as  one 
combining  ample  security  of  principal  and  in- 
terest, a  good  rate  of  income,  ready  convert- 
ibility into  cash,  and  reasonable  promise  of 
appreciation  in  value.  Measured  by  the  re- 
quirements of  this  definition,  the  conclusion 
seems  justified  that  well-selected  railroad 
bonds,  if  purchased  under  favorable  money- 
market  conditions,  afford  a  highly  desirable 
form  of  investment. 


Ill 


RAILROAD  EQUIPMENT  BONDS 

A  S  its  name  implies,  an  equipment  bond  is 
**•  one  issued  by  a  railroad  to  provide  funds 
with  which  to  pay  for  new  rolling  stock — cars 
and  locomotives.  The  issues  are  variously  de- 
scribed as  car  trust  certificates,  equipment 
bonds,  or  equipment  notes.  They  conform  in 
•general  to  one  of  two  standard  forms :  ( i )  The 
conditional  sale  plan :  In  accordance  with  speci- 
fications furnished  by  the  railroad,  the  trustee 
selected  (usually  a  trust  company)  contracts 
with  the  builders  for  the  purchase  of  the  equip- 
ment. From  i  o  to  20  per  cent  of  the  cost  of 
the  equipment  is  paid  in  cash  by  the  railroad 
and  the  rest  is  represented  by  the  equipment 
bonds.  The  bonds  are  the  direct  obligation  of 
the  railroad  company.  They  are  secured  by  a 
first  lien  upon  the  entire  equipment  purchased. 
The  title  to  the  equipment  remains  in  the  trus- 
tee for  the  benefit  of  the  bondholders  until  the 
last  bond  has  been  paid,  so  that  under  no  cir- 
cumstances can  the  general  mortgages  of  the 
40 


RAILROAD    EQUIPMENT    BONDS  41 

railroad  attach  as  a  first  lien  on  the  equipment 
ahead  of  the  car  trust  obligations.  After  the 
final  payment,  the  trustee  assigns  title  to  the 
railroad  company,  which  thereupon  becomes 
the  owner  in  fee  of  the  equipment.  Under  the 
terms  of  the  deed  of  trust  the  railroad  is  always 
obliged  to  keep  the  equipment  fully  insured,  in 
good  order  and  complete  repair,  and  to  replace 
any  equipment  which  may  become  worn  out, 
lost,  or  destroyed.  The  bonds  are  usually 
issued  in  coupon  form,  $1,000  each,  bearing 
semiannual  interest,  with  provision  for  regis- 
tration. They  are  generally  paid  off  in  semi- 
annual or  annual  instalments  of  substan- 
tially equal  amounts,  the  last  instalment  usually 
falling  due  in  ten  years,  a  period  well  within 
the  life  of  the  equipment  as  estimated  under 
the  master  car  builder's  rules.  Occasionally 
this  method  of  payment  is  altered  by  the  substi- 
tution of  a  sinking  fund,  the  bonds  having  a 
uniform  fixt  maturity,  but  subject  to  the  opera- 
tion of  a  sinking  fund  which  is  sufficient  to 
retire  the  entire  issue  well  within  the  life  of  the 
equipment.  In  either  case  the  security,  ample 
at  the  outset,  increases  proportionally  with  the 
reduction  in  obligations  outstanding  against  it. 


42       HOW   TO    INVEST    MONEY 

(2)  The  so-called  "Philadelphia  plan."  Un- 
der this  plan  the  equipment  is  purchased  by  an 
individual,  association,  or  corporation  which 
leases  the  equipment  to  the  railroad  for  a  term 
of  years  at  a  rental  equivalent  to  the  interest 
and  maturing  instalments  of  the  bonds.  The 
contract  of  lease  is  then  assigned  to  a  trust  com- 
pany as  trustee,  which  thereupon  issues  its  cer- 
tificates in  substantially  the  form  described  in 
the  plan  above,  these  representing  a  beneficial 
interest  in  the  equipment,  which  are  usually 
guaranteed  both  principal  and  interest  by  the 
railroad.  The  lease  runs  until  the  last  bond 
has  been  paid,  after  which  the  trustee  assigns 
title  to  the  railroad  as  above.  The  chief  advan- 
tage of  this  plan  over  the  other  is  that  in  some 
States,  notably  Pennsylvania,  certificates  issued 
in  accordance  with  its  terms  are  exempt  from 
taxation,  whereas  under  the  conditional  sale 
plan,  as  the  direct  obligation  of  the  railroad, 
the  bonds  would  be  taxable. 

It  is  evident  from  the  foregoing  description 
that  equipment  bonds  differ  in  two  important 
respects  from  all  other  classes  of  railroad 
issues.  First,  the  title  to  the  property  which 
secures  the  bonds  does  not  vest  in  the  railroad ; 


RAILROAD    EQUIPMENT    BONDS  43 

and,  secondly,  the  property  is  movable  and  not 
fixt  in  any  one  locality. 

By  virtue  of  these  two  points,  the  holders 
of  equipment  bonds  possess  a  great  advantage 
over  the  holders  of  mortgage  bonds  in  the  event 
of  a  railroad's  becoming  bankrupt. 

If  a  railroad  is  unable  to  meet  its  interest 
charges,  the  mortgage  bondholders  can  rarely 
do  better  than  have  a  receiver  appointed 
who  will  operate  the  railroad  in  their  interest ; 
but  if,  with  honest  and  efficient  management, 
the  railroad  can  not  be  made  to  earn  its  interest 
charges,  the  mortgage  bondholders  usually 
have  to  consent  to  the  scaling  of  their  bonds 
to  a  point  where  the  railroad  can  operate  upon 
a  paying  basis. 

With  the  holders  of  equipment  bonds  the 
case  is  quite  different.  If  the  receiver  defaults 
upon  their  bonds  they  have  only  to  direct  the 
trustee  to  enter  upon  possession  of  the  equip- 
ment and  sell  it  or  lease  it  to  some  other  rail- 
road. The  knowledge  that  they  possess  this 
power  renders  its  exercise  generally  unneces- 
sary. The  equipment  of  a  railroad  is  essential 
to  its  operation.  It  is  the  tool  with  which  the 
railroad  handles  its  business.  If  the  receiver 


44       HOW   TO    INVEST    MONEY 

were  deprived  of  the  equipment  it  would  be  im- 
possible for  him  to  operate  the  road,  and  so 
he  could  never  satisfy  its  creditors.  Conse- 
quently the  courts,  both  State  and  Federal,  have 
ruled  that  the  necessary  equipment  of  a  bank- 
rupt railroad  must  be  preserved,  and  have 
placed  the  charges  for  principal  and  interest  of 
equipment  obligations  upon  an  equality  with 
charges  for  wages,  materials,  and  other  opera- 
ting expenses,  and  in  priority  to  interest  of  even 
first-mortgage  bonds. 

These  points  sufficiently  explain  the  remark- 
able record  which  equipment  bonds  have  made 
during  reorganizations.  Careful  investigation 
has  been  made  of  the  various  railroads  which 
were  reorganized,  either  with  or  without  fore- 
closure, between  the  years  1888  and  1905.  This 
covers  the  chief  period  of  railroad  receivership. 
It  was  discovered  that  sixteen  different  rail- 
roads, aggregating  nearly  one  hundred  thou- 
sand miles  and  located  in  widely  different  parts 
of  the  country,  had  outstanding  equipment 
bonds  at  the  time  of  default.  In  every  case  the 
principal  and  interest  of  equipment  bonds  were 
paid  in  full,  while  all  other  securities,  with  a 
few  exceptions,  were  reduced  in  rate  or  amount 


RAILROAD    EQUIPMENT    BONDS  45 

or  both.  Two  of  these  railroads  offered  to  the 
holders  of  equipment  bonds  the  option  of  an 
advantageous  exchange  of  securities,  which 
amounted  to  more  than  payment  in  full. 

The  foregoing  facts  justify  the  conclusion 
that  equipment  bonds  possess  security  equal  or 
superior  to  that  of  any  other  form  of  railroad 
bonds. 

Let  us  now  consider  their  remaining  char- 
acteristics— their  rate  of  income,  convertibility, 
prospect  of  appreciation  in  value,  and  stability 
of  market  price. 

One  of  the  strongest  features  of  equipment 
bonds  is  the  relatively  high  rate  of  income 
which  they  yield.  The  amount  realized  varies 
in  accordance  with  the  financial  strength  and 
credit  of  the  issuing  railroad,  and  the  margin 
of  security  in  the  equipment  itself.  As  a  gen- 
eral rule,  the  net  return  on  the  equipment  bonds 
of  a  given  railroad  is  usually  from  *4  per  cent 
to  %  Per  cent  greater  than  on  the  first-mort- 
gage bonds  of  the  same  railroad.  This  is 
owing  to  the  fact  that  while  banks  and  scientific 
investors  have  bought  equipment  bonds  for 
many  years,  the  general  public  is  not  suffi- 
ciently familiar  with  the  inherent  strength  of 


46       HOW   TO    INVEST    MONEY 

these  issues  to  create  much  of  a  demand  for 
them.    This  insures  a  good  return. 

Equipment  bonds  vary  in  point  of  convert- 
ibility. The  reader  will  remember  from  the 
description  above  that  equipment  bonds  are  usu- 
ally issued  in  serial  form,  with  instalments  ma- 
turing semiannually  from  six  months  to  ten 
years.  By  confining  purchases  to  the  shorter 
maturities,  say  within  two  or  three  years,  a  high 
degree  of  convertibility  may  usually  be  obtained 
because  the  short  maturities  are  greatly  sought 
by  banks  and  other  financial  institutions  which 
regard  equipment  bonds  in  much  the  same  light 
as  merchant's  paper  or  time  loans  secured  by  col- 
lateral. At  a  price  equivalent  to  the  rate  which 
the  best  commercial  paper  commands,  there  is 
always  a  good  demand  from  the  banks.  Many 
banks  prefer  equipment  bonds  to  loans  or  paper 
on  account  of  their  greater  convertibility.  As 
the  length  of  maturity  increases,  the  degree  of 
convertibility  generall}  decreases,  because  the 
chief  demand  for  the  longer  dates  comes  from 
insurance  companies,  which  do  not,  in  the  ag- 
gregate, constitute  as  great  a  demand  as  the 
banks.  When  the  demand  from  private  invest- 
ors increases,  as  it  undoubtedly  will  when  they 


RAILROAD    EQUIPMENT    BONDS  47 

become  more  familiar  with  the  desirable  points 
of  these  issues,  all  maturities  will  probably  pos- 
sess ready  convertibility. 

In  the  same  way,  equipment  bonds  vary  as 
to  stability  of  market  price.  Compared  with 
other  classes  of  railroad  issues,  equipment 
bonds  are  all  relatively  stable,  but  the  stability 
is  especially  marked  in  the  shorter  maturities. 

Equipment  bonds  possess  little  prospect  of 
appreciation  in  value. 

The  attentive  reader  who  has  carefully  fol- 
lowed the  foregoing  description  of  equipment 
bonds,  may  have  noticed  a  special  adaptability 
on  their  part  to  the  requirements  of  a  business 
surplus.  Broadly  speaking,  for  such  invest- 
ment, a  security  is  required  which  will  combine 
perfect  safety  of  principal  and  interest,  a  good 
rate  of  income,  ready  convertibility  into  cash, 
and  unyielding  stability  of  market  price.  The 
necessity  for  insistence  upon  these  requirements 
in  the  investment  of  a  business  surplus  will 
appear  upon  a  moment's  reflection.  Safety  is 
required  in  all  forms  of  investment,  but  is  par- 
ticularly important  in  the  handling  of  business 
funds ;  a  good  rate  of  income  is  always  desira- 
ble; convertibility  is  necessary  for  a  business 


48       HOW   TO    INVEST    MONEY 

surplus  so  that  the  reserve  funds  may  be  con- 
verted into  cash  at  any  time;  and  it  is  of  the 
utmost  importance  that  the  security  should  not 
shrink  materially  in  quoted  price,  no  matter 
what  changes  may  take  place  in  financial  and 
business  conditions,  so  that  if  the  need  should 
arise  for  realizing  on  the  reserve  fund,  it  would 
be  found  unimpaired  in  amount.  As  explained 
in  a  former  chapter,  this  point  can  not  be  cov- 
ered by  the  selection  of  securities  perfectly  safe 
as  to  principal  and  interest,  but  only  by  the  pur- 
chase of  short-term  obligations. 

The  point  may  be  illustrated  as  follows :  Let 
it  be  supposed  that  a  firm  or  company  has  de- 
cided to  invest  $100,000  in  the  5-per-cent  equip- 
ment bonds  of  a  good  railroad  maturing  in 
three  years,  which  can  be  obtained  at  par,  mer- 
chant's paper  then  commanding  about  5^2  per 
cent.  After  two  years  it  becomes  necessary  for 
the  firm  to  realize  on  its  investment  at  a  time 
when  commercial  paper  is  floated  with  difficulty 
on  a  6^-per-cent  or  7-per-cent  basis.  Under 
such  money  conditions  the  equipment  bonds 
could  be  sold  on  about  a  6-per-cent  basis,  which 
would  mean  a  price  of  99  for  a  5-per-cent  bond 
with  one  year  to  run.  The  firm,  in  liquidating 


RAILROAD    EQUIPMENT    BONDS  49 

its  investment,  would  therefore  lose  i  per  cent 
in  principal,  but  would  have  received  5  per  cent 
interest  for  two  years,  making  the  net  return 
4l/2  per  cent.  Compare  this  showing  with  the 
result  if  the  bonds  when  originally  bought  had 
had  ten  years  to  run  instead  of  three. 

After  two  years,  when  the  firm  wished  to 
dispose  of  its  bonds  it  might  experience  some 
difficulty  in  doing  so  in  the  stringent  money 
market  which  has  been  supposed,  but  even  if 
it  succeeded  in  selling  them  upon  a  6-per-cent 
basis,  that  would  mean  a  price  of  only  93^  and 
would  represent  6^-per-cent  loss  in  principal. 
If  it  were  necessary  to  sell  the  bonds  upon  a 
higher  basis  or  if  the  firm  had  purchased  a  bond 
with  more  than  ten  years  to  run,  the  relative 
disadvantage  of  the  longer  bond  would  be  still 
more  apparent.  These  points  sufficiently  de- 
monstrate the  importance  of  buying  only  short- 
term  securities  for  the  investment  of  a  business 
surplus.  Of  course,  if  money  conditions  im- 
prove instead  of  becoming  worse  between  the 
dates  of  purchase  and  sale,  then  a  greater  profit 
would  be  made  with  the  longer-term  bond. 
This,  however,  should  not  be  allowed  to  in- 
fluence the  choice,  first  because  it  is  not  the 


50       HOW   TO    INVEST    MONEY 

object  of  a  reserve  fund  to  make  a  speculative 
profit,  and  secondly  because  a  firm  or  corpora- 
tion is  only  likely  to  want  to  realize  upon  its 
reserve  fund  when  money  is  hard  to  obtain 
otherwise,  and  that  is  precisely  the  time  when 
any  long-term  bond  would  be  apt  to  show  con- 
siderable depreciation. 

The  foregoing  considerations  indicate  a  spe- 
cial adaptability  on  the  part  of  equipment  bonds 
to  the  usual  requirements  of  a  business  surplus. 
The  points  have  been  brought  out  at  some 
length  because  of  the  importance  of  the  subject 
to  the  average  business  man.  The  purpose  in 
concentrating  attention  upon  a  single  instance 
has  been  to  illustrate  more  clearly  the  princi- 
ples involved  and  at  the  same  time  to  acquaint 
the  business  man  with  details  of  a  highly 
desirable  and  somewhat  unfamiliar  form  of 
security. 


IV 


REAL-ESTATE  MORTGAGES 

IN  the  preceding  chapter  the  discussion  of 
railroad  bonds  was  brought  to  a  close.  Be- 
fore passing  to  the  consideration  of  real-estate 
mortgages,  which  is  the  next  form  of  invest- 
ment to  be  taken  up,  it  may  be  well  to  review 
briefly  the  general  principles  advanced  in  the 
first  chapter  of  this  book,  in  order  that  the 
reader  may  have  clearly  in  mind  the  main 
points  upon  which  judgment  of  the  value  of  in- 
vestments should  be  based. 

There  are  five  chief  points  to  be  considered 
in  the  selection  of  all  forms  of  investment. 
These  are :  ( i )  safety  of  principal  and  interest ; 
(2)  rate  of  income;  (3)  convertibility  into 
cash;  (4)  prospect  of  appreciation  in  intrinsic 
value;  (5)  stability  of  market  price. 

Keeping  these  five  general  factors  in  mind, 
the  present  chapter  will  discuss  real-estate 
mortgages  as  a  form  of  investment,  both  as 
adapted  to  the  requirements  of  private  funds 
and  of  a  business  surplus. 

51 


52       HOW   TO    INVEST    MONEY 

The  average  American  business  man  is  so 
familiar  with  real-estate  mortgages  that  the 
details  may  be  passed  over  briefly.  A  real- 
estate  mortgage,  or  a  bond  and  mortgage,  as 
it  is  sometimes  called,  consists  essentially  of 
two  parts,  a  bond  or  promise  to  pay  a  certain 
sum  of  money  at  a  future  date  with  interest  at 
a  certain  rate  per  annum,  and  a  mortgage  or 
trust  deed  transferring  title  and  ownership  in 
a  piece  of  real  estate,  with  the  provision  that 
the  transfer  shall  be  void  if  the  interest  is  regu- 
larly paid  and  the  bond  redeemed  at  maturity. 
Before  advancing  money  on  the  security  of  a 
mortgage  it  is  necessary  to  determine  whether 
the  title  to  the  property  legally  vests  in  the 
maker  of  the  mortgage ;  and  during  the  contin- 
uance of  the  mortgage  it  is  necessary  to  have 
proof  that  the  taxes  and  assessments  are  being 
regularly  paid,  and,  in  the  case  of  improved 
property,  the  fire-insurance  as  well. 

The  safety  of  real-estate  mortgages,  in  com- 
mon with  the  safety  of  all  obligations,  depends 
upon  the  margin  of  security  in  excess  of  the 
amount  of  the  loan.  In  the  case  of  real-estate 
mortgages  the  amount  of  this  margin  may  be 
determined  without  great  difficulty.  It  is  only 


REAL-ESTATE   MORTGAGES       53 

necessary  to  have  the  property  carefully  ap- 
praised by  an  expert  in  real-estate  values.  It 
does  not  follow,  however,  because  a  mortgage 
has  been  shown  to  possess  substantial  equity, 
that  it  is  perfectly  safe  as  an  investment,  unless  it 
satisfies  also  another  condition  of  great  impor- 
tance. A  mortgage  may  not  exceed  50  per  cent, 
of  the  selling  value  of  the  real  estate  pledged, 
and  yet  be  a  poor  investment.  This  point  in- 
volves a  serious  objection  to  real-estate  mort- 
gages which  sometimes  escapes  notice. 

The  holder  of  a  mortgage  is  at  a  great  dis- 
advantage in  regard  to  the  changing  value  of 
real  estate.  If  the  value  of  the  property  upon 
which  he  holds  a  mortgage  increases,  the  addi- 
tional value  enhances  the  security  of  the  loan, 
but  does  not  add  to  the  principal  which  he  has 
invested,  while  if  the  value  of  the  property  di- 
minishes, not  only  is  the  security  proportion- 
ately lessened,  but  if  the  impairment  be  great, 
the  holder  is  frequently  compelled  to  take  over 
the  property  and  may  suffer  loss  of  principal. 
In  other  words,  he  receives  no  direct  benefit 
from  an  increase  in  the  value  of  the  property, 
but  has  to  stand  the  larger  part  of  the  risk  of/ 
a  decline  in  its  value. 


54       HOW   TO    INVEST    MONEY 

This  is  not  the  case  with  investments  repre- 
sented by  negotiable  securities  subject  to  chan- 
ging market  quotations.  All  such  securities, 
railroad  bonds  for  example,  are  acted  on 
equally  by  changes  in  the  value  of  the  property 
which  secures  them.  Except  for  the  influences 
of  money-market  conditions,  railroad  bonds  ad- 
vance with  an  increase  in  the  value  of  the  prop- 
erty and  decline  with  a  decrease  in  its  value. 
Well-selected  bonds  usually  increase  in  value 
with  time,  and  all  such  increase  goes  directly 
to  the  benefit  of  the  holder.  The  failure  of  real- 
estate  mortgages  to  respond  similarly  to 
changes  in  the  value  of  property  places  the 
holder  of  a  mortgage  at  a  great  disad- 
vantage. 

Owing  to  this  characteristic,  real-estate 
mortgages  should  be  purchased  only  when  gen- 
eral conditions  in  the  real-estate  market  are 
distinctly  favorable.  Not  only  should  the  pur- 
chaser of  a  mortgage  have  sufficient  margin  of 
security  in  the  particular  piece  of  property  upon 
which  he  is  loaning  money,  but  he  should  also 
be  satisfied  that  general  real-estate  values  are 
relatively  low,  that  there  has  been  no  undue 
speculation,  and  that  conditions  favor  an  ad- 


REAL-ESTATE    MORTGAGES       55 

vance    rather    than    a    decline    in    real-estate 
prices. 

No  class  of  property  is  subject  to  more  rapid 
changes  in  value  than  real  estate.  After  an 
extensive  advance  the  holder  of  a  mortgage 
may  be  insufficiently  protected  by  the  equity  in 
the  property,  even  if  his  mortgage  represents 
only  60  per  cent  of  the  current  appraised  value 
of  the  real  estate  pledged.  It  may  be  that  the 
60  per  cent. which  he  has  loaned  represents  the 
total  value  or  more  than  the  total  value  a  few 
years  before.  When  a  rapid  advance  in  values 
occurs,  tho  it  may  be  largely  justified  by  the 
growth  and  development  of  the  territory,  there 
is  sure  to  be  present  an  element  of  speculation 
which  is  likely  to  carry  prices  beyond  the  point 
of  reason.  When  the  turn  comes  and  a  severe 
collapse  takes  place,  its  effects  are  extremely 
disastrous,  because,  unlike  speculation  in  stocks 
or  commodities,  no  short  selling  exists  in  real 
estate  to  temper  the  fall,  and  the  immobile  form 
of  capital  makes  liquidation  impossible.  These 
considerations  serve  to  show  the  need  for  great 
prudence  in  the  purchase  of  real-estate  mort- 
gages. If  the  investor  exercises  due  care  in 
these  particulars,  he  is  reasonably  sure  of 


56       HOW   TO    INVEST    MONEY 

obtaining  a  very  high-grade  security;  if  he 
neglects  these  precautions,  he  may  suffer  severe 
loss  of  principal. 

No  general  figures  are  available  which  would 
indicate  the  degree  of  certainty  attaching  to 
the  payment  of  interest  upon  real-estate  mort- 
gages. Certain  classes  of  mortgages,  such  as 
those  secured  by  unimproved  real  estate  or 
dwellings,  afford  no  direct  security  of  interest 
payment  other  than  the  threat  of  foreclosure. 
Other  classes,  such  as  mortgages  upon  stores, 
hotels,  or  office-buildings,  are  often  protected 
by  a  large  income  from  the  direct  operation  of 
the  mortgaged  premises,  thus  furnishing  a 
security  for  the  annual  interest  payment.  The 
margin  of  protection  in  these  cases  varies 
greatly,  so  that  no  general  conclusion  can  be 
drawn. 

The  other  characteristics  of  real-estate  mort- 
gages may  be  passed  over  more  briefly.  It  is 
generally  conceded  that  mortgages  return  a 
higher  rate  of  income  than  can  be  obtained 
upon  any  other  form  of  investment  which 
affords  equal  security.  This  constitutes  their 
chief  advantage. 

Their  chief  disadvantage,  on  the  other  hand, 


REAL-ESTATE    MORTGAGES      57 

lies  in  their  entire  want  of  convertibility.  There 
is  no  market  for  real-estate  mortgages,  and 
except  in  special  instances  they  can  not  be 
readily  sold.  The  fact  that  they  are  not  sub- 
ject to  quotation  prevents  them  also  from  hold- 
ing out  any  prospect  of  appreciation  in  value. 
Their  very  deficiency  in  this  respect,  however, 
constitutes  an  important  advantage  from  an- 
other point  of  view.  Since  they  are  not  quoted 
they  can  not  shrink  in  market  price  in  obedience 
to  changes  in  financial  and  business  conditions. 
The  buyer  of  a  mortgage  is  assured  that  he  can 
carry  his  mortgage  at  par  through  periods 
when  it  may  be  necessary  to  mark  down  all 
negotiable  securities  subject  to  changing  mar- 
ket quotations.  This  is  frequently  a  matter  of 
great  importance. 

The  general  characteristics  of  real-estate 
mortgages  may  be  summarized  as  follows :  ( I ) 
When  carefully  selected  and  purchased  under 
favorable  conditions,  great  safety  of  principal 
and  interest;  (2)  a  relatively  high  return;  (3) 
a  low  degree  of  convertibility;  (4)  no  prospect 
of  appreciation  in  value;  and  (5)  the  practical 
certainty  of  maintaining  the  integrity  of  the 
principal  invested. 


58       HOW    TO    INVEST    MONEY 

Is  a  security  possessing  these  characteristics 
a  suitable  investment  for  a  business  surplus? 
Only  to  a  limited  extent.  The  safety,  high  re- 
turn, and  assurance  against  loss  in  quoted  value 
of  principal  are  all  highly  desirable  qualities 
for  this  purpose,  but  the  lack  of  convertibility 
is  a  fatal  defect.  No  consideration  is  of  greater 
importance  in  the  investment  of  a  business  sur- 
plus than  a  high  degree  of  convertibility,  so 
that  if  the  need  should  arise  the  investment 
may  be  instantly  liquidated.  The  fact  that  real- 
estate  mortgages  can  not  be  readily  disposed 
of  makes  it  practically  impossible  to  employ 
them  for  the  investment  of  a  business  surplus. 

Where  convertibility  is  not  an  essential  re- 
quirement, and  where  the  want  of  promise  of 
appreciation  in  value  is  not  a  serious  matter, 
mortgages  afford  a  very  desirable  form  of  in- 
vestment. The  characteristics  which  they  pos- 
sess in  an  eminent  degree — safety,  high  return, 
and  assurance  against  loss  in  quoted  value  of 
principal — are  exactly  suited  to  the  ordinary 
requirements  of  savings-banks.  Generally 
speaking,  only  a  small  proportion  of  a  savings- 
bank's  assets  need  be  kept  in  liquid  form  or 
readily  convertible,  and  accordingly  they  find 
mortgages  highly  desirable. 


REAL-ESTATE   MORTGAGES      59 

For  the  purpose  of  private  investment  the 
attractiveness  of  mortgages  is  not  so  easy  to 
determine.  Ordinarily,  fluctations  in  quoted 
values  are  of  no  great  importance  to  the  pri- 
vate investor,  so  that  the  absence  of  quotation 
which  mortgages  enjoy  is  not  especially  valu- 
able. Their  safety  and  high  return  are  attrac- 
tive qualities,  but  their  want  of  convertibility 
and  of  prospect  of  appreciation  in  value  are 
drawbacks.  On  the  whole,  the  private  investor 
may  probably  employ  with  advantage  a  certain 
part,  but  not  too  much  of  his  estate  in  mortgage 
investments. 

As  part  of  a  scientific  and  comprehensive 
scheme  of  investment,  the  special  advantages  of 
real-estate  mortgages  appear  most  promi- 
nently in  the  years  following  a  business  de- 
pression. During  such  a  period  real-estate 
values  are  usually  relatively  low,  but  beginning 
to  advance,  so  that  mortgages  present  their 
maximum  margin  of  security.  At  such  a  time 
they  compare  most  favorably  with  bonds  and 
other  investment  securities  which  are  subject  to 
changing  quotations,  because  such  securities 
are  then  apt  to  be  at  their  highest  point  under 
the  combined  influence  of  restored  confidence 


60       HOW    TO    INVEST    MONEY 

and  the  low  money  rates  which  usually  prevail. 
After  several  years  of  continued  and  increasing 
business  prosperity  the  positions  are  just 
reversed. 

No  discussion  of  real-estate  mortgages 
would  be  complete  without  allusion  to  the  guar- 
anteed mortgages  which  have  been  placed  upon 
the  market  in  great  quantities  within  the  past 
few  years.  Guaranteed  mortgages  are  real- 
estate  mortgages  guaranteed  as  to  principal 
and  interest  by  substantial  companies  having 
large  capital  and  surplus.  In  addition  to  the 
guaranty,  the  companies  usually  search  and 
guarantee  the  title,  see  to  it  that  the  taxes, 
assessments,  and  insurance  are  paid,  and  per- 
form the  other  services  of  a  real-estate  broker. 
Their  compensation  varies  somewhat,  but  prob- 
ably averages  J4  per  cent — that  is,  for  example, 
they  loan  at  5  per  cent  and  sell  guaranteed 
mortgages  to  the  investor  at  4^. 

The  value  of  the  guaranty  may  be  considered 
from  two  points  of  view — first,  in  the  event  of 
a  general  decline  in  real-estate  values,  and, 
secondly,  when  a  fall  occurs  in  a  particular 
piece  of  property  or  in  a  particular  locality. 

If  a  severe  decline  in  real-estate  values  takes 


REAL-ESTATE    MORTGAGES      61 

place,  affecting  all  localities,  it  might  become 
necessary  for  the  holders  of  guaranteed  mort- 
gages to  test  the  value  of  their  guaranties.  In 
such  a  case  the  question  would  arise  how  far 
the  capital  and  surplus  of  the  guaranteeing 
companies  would  extend  in  liquidating  the 
mortgages  which  they  had  guaranteed.  This 
would  depend  entirely  upon  the  proportion  be- 
tween the  capital  and  surplus  of  the  companies 
and  the  total  amount  of  outstanding  mortgages 
guaranteed.  Ordinarily  the  capital  and  surplus 
do  not  exceed  5  per  cent  of  the  mortgages,  so 
that  the  average  guaranty  is  good  for  about  5 
per  cent  additional  equity.  On  a  piece  of  prop- 
erty worth  $100,000,  upon  which  a  guaranteed 
mortgage  of  $60,000  exists,  the  guaranty  would 
be  worth  $3,000,  and  would  margin  the  prop- 
erty down  to  $57,000.  This  additional  equity 
is  of  little  value.  It  is  probably  unlikely  that  a 
4O-per-cent  depreciation  in  value  will  take 
place,  but  the  guaranty  is  not  needed  unless  it 
does,  and  if  it  should  occur,  the  depreciation  is 
quite  as  likely  to  go  to  50  per  cent  or  more  as 
to  stop  at  43. 

From  the  second  point  of  view  the  value  of 
the  guaranty  is  much  greater.     The  distribu- 


62       HOW   TO    INVEST    MONEY 

tion  of  risk,  as  in  the  case  of  fire-insurance,  pro- 
tects the  holder  against  loss  in  the  event  of  a 
fall  in  the  particular  piece  of  property  upon 
which  he  holds  a  mortgage,  or  even  in  a  partic- 
ular locality.  It  can  not  be  said,  however,  that 
the  records  are  yet  sufficiently  complete  to  form 
a  conclusion  as  to  what  is  a  safe  proportion 
between  capital  and  surplus  and  outstanding 
mortgages.  Further  than  that  the  guarantee- 
ing companies,  generally  speaking,  have  been 
operating  since  their  inception  upon  a  rising 
market,  so  that  their  success  hitherto  has  not 
been  remarkable.  Allowing  for  these  draw- 
backs, however,  the  private  investor,  unless  so 
situated  as  to  give  personal  attention  to  the 
details  of  his  investments,  will  probably  do  well 
to  purchase  his  mortgages  in  guaranteed  form. 


INDUSTRIAL  BONDS 

INDUSTRIAL  bonds  include  the  obligations 
*  of  all  manufacturing  and  mercantile  com- 
panies, and  miscellaneous  companies  of  a  pri- 
vate character.  They  form  a  class  quite  distinct 
from  railroad  bonds  or  public-utility  bonds. 

I.  Safety  of  Principal  and  Interest.  The 
safety  of  industrial  bonds,  in  common  with  the 
safety  of  all  forms  of  investment,  depends  upon 
the  margin  of  security  in  excess  of  the  amount 
of  the  obligation.  'In  the  case  of  industrial  bonds 
the  amount  of  this  margin  is  not  always  easy  to 
determine.  Even  when  determined,  the  rule  is 
difficult  of  application  because  a  margin  which 
may  seem  insufficient  from  the  point  of  view  of 
physical  valuation  may  be  satisfactory  when 
considered  as  the  equity  of  a  working  concern. 
The  indications  most  to  be  relied  upon  in  esti- 
mating the  safety  of  industrial  bonds  are  as 
follows : 

(a)     Value  of  real  estate.    The  first  point 


64       HOW    TO    INVEST    MONEY 

to  be  determined  in  considering  the  purchase  of 
an  industrial  bond  is  the  value  of  the  real  estate 
upon  which  it  is  a  first  mortgage.  If  the  ap- 
praised value  of  the  ground,  irrespective  of  the 
buildings  and  machinery  upon  it,  is  greater  by 
a  substantial  sum  than  the  amount  of  the  bond 
issue,  the  obligation  is  practically  a  real-estate 
mortgage.  In  such  a  case,  while  possibly 
"slow,"  i.e.,  secured  by  an  assets  difficult  to  rea- 
lize upon — the  safety  of  the  bond  can  hardly 
be  questioned.  In  judging  a  bond  upon  its  real- 
estate  value,  it  is  not  always  safe  to  take  the 
cost  price  of  the  land  as  shown  by  the  com- 
pany's books,  because  frequently  the  cost  upon 
the  books  is  artificially  raised  by  payment  hav- 
ing been  made  in  securities  whose  market  value 
is  less  than  par,  or  in  other  ways.  As  stated 
above,  judgment  should  be  based  upon  the 
appraised  value  of  the  land. 

If  the  bond  meets  this  test  satisfactorily,  the 
prospective  investor  may  feel  reasonably  sure 
that  the  safety  of  his  principal  is  not  in  ques- 
tion, and  may  buy  the  bond  without  anxiety 
if  it  satisfies  his  other  requirements.  On  the 
other  hand,  if  the  bond  only  partially  meets  this 
test,  and  it  appears  that  some  part  of  its  value 


INDUSTRIAL    BONDS  65 

comes  from  plant  and  equipment  and  from  the 
strength  of  the  company  as  a  working  concern, 
then  it  is  necessary  for  the  investor  to  consider 
carefully  several  other  factors. 

(b)  Net  quick  assets.  The  balance-sheet  of 
every  industrial  company  can  be  divided  hori- 
zontally into  two  parts.  Its  assets  are  of  two 
kinds — property  assets,  which  are  fixt,  and  cur- 
rent assets,  which  are  fluid.  Similarly,  its  lia- 
bilities are  of  two  kinds — capital  liabilities  and 
current  liabilities.  It  requires  no  very  extended 
business  experience  to  pick  out  the  items  which 
make  up  these  totals.  Plant  and  property  assets 
are  usually  lumped  together  under  the  head, 
"Cost  of  Property."  Current  assets  include  in- 
ventories, bills  and  accounts  receivable,  agents' 
balances,  marketable  securities,  and  cash  on 
hand  and  in  banks — everything,  in  short,  which 
can  be  quickly  converted  into  cash.  On  the 
other  side  of  the  balance-sheet,  capital  liabilities 
are  easily  determined.  They  consist  of  the  par 
amounts  of  bonds  and  stocks  outstanding.  Cur- 
rent liabilities  comprise  bills  and  accounts  paya- 
ble, including  borrowed  money,  pay-rolls,  and 
interest  and  taxes  accrued  but  not  due. 

The  real  strength  of  every  industrial  con- 


66       HOW    TO    INVEST    MONEY 

cern  is  to  be  learned  from  the  figures  relating 
to  its  current  accounts.  Property  assets  and 
capital  liabilities  are  not  of  the  same  signifi- 
cance. If  the  cost  of  plant  and  equipment  as 
shown  by  the  books  exceeds  its  real  value,  the 
market  usually  makes  the  necessary  adjustment 
by  putting  a  price  less  than  par  upon  the  bonds 
and  stocks. 

No  such  process  is  possible  in  the  case  of  the 
current  accounts.  If  the  current  liabilities  ex- 
ceed the  current  assets  the  company  shows  a 
deficit,  whatever  its  surplus  may  show  on  the 
books.  On  the  other  hand,  if  the  current  assets 
are  greater  than  the  current  liabilities,  the  com- 
pany possesses  a  working  capital,  represented 
by  the  difference  between  the  two,  and  known 
as  net  quick  assets. 

There  are  three  things  to  consider  in  connec- 
tion with  net  quick  assets:  First,  the  propor- 
tion between  current  assets  and  current  liabil- 
ities. To  put  a  company  in  good  shape  its 
current  assets  should  be  at  least  twice  as  great 
as  its  current  liabilities.  Two  for  one  is  a  fair 
proportion,  tho  some  companies  show  as  much 
as  six  to  one.  The  stronger  a  company  is  in 
this  proportion  the  better. 


INDUSTRIAL    BONDS  67 

Secondly,  the  proportion  between  net  quick 
assets  and  bonded  debt.  The  bonded  debt 
should  never  exceed  net  quick  assets,  except 
when  the  company  possesses  real  estate,  in 
which  case  two-thirds  of  the  real-estate  value 
plus  the  net  quick  assets  should  cover  the  bonds. 
Some  companies  do  much  better  than  that.  One 
prominent  company  in  this  country,  altho  it  pos- 
sesses real  estate  of  considerable  value,  has 
agreed  in  the  indenture  securing  its  bonds  to 
keep  net  quick  assets  at  all  times  greater  by  a 
substantial  margin  than  the  amount  of  bonds 
outstanding. 

Thirdly,  the  proportion  between  net  quick 
assets  and  the  surplus  as  shown  in  the  balance- 
sheet.  If  the  capital  liabilities  exactly  balance 
the  property  assets,  it  is  plain  that  the  surplus 
will  exactly  balance  the  net  quick  assets.  If 
the  surplus  is  smaller  than  net  quick  assets,  it 
is  usually  a  sign  that  capital  liabilities  have 
been  created  to  provide  working  capital.  Opin- 
ions differ  as  to  the  wisdom  of  this  course. 
Generally  speaking,  it  is  better  to  provide  work- 
ing capital  by  means  of  a  stock  issue  than  to 
depend  upon  the  banks  for  accommodation. 
The  exception  to  this  rule  occurs  in  the  case 


68       HOW   TO    INVEST    MONEY 

of  companies  that  require  a  great  deal  of  work- 
ing capital  for  part  of  the  year  and  only  a  little 
at  other  times.  If  they  have  the  best  banking 
connections,  such  companies  may  be  safe  in  de- 
pending upon  their  banks  to  carry  them,  but  if 
they  do  so,  they  should  have  no  bonded  or  other 
fixt  indebtedness  which  would  prevent  their 
paper  from  being  a  first  lien  upon  their  entire 
assets. 

If  working  capital  is  to  be  created  by  the 
issue  of  capital  liabilities,  it  is  much  better  that 
it  should  be  done  by  stocks  than  by  bonds.  The 
ideal  method,  however,  is  to  provide  only  such 
an  amount  of  working  capital  at  the  organiza- 
tion of  a  company  as  is  necessary  for  the  con- 
duct of  its  business,  and  then,  as  the  volume 
of  its  business  grows,  to  accumulate  the  addi- 
tional amount  necessary  out  of  earnings, 
refraining  from  the  payment  of  dividends  until 
the  fund  is  complete. 

Before  leaving  the  subject  of  net  quick  assets, 
it  is  well  to  note  the  importance  of  the  figure 
showing  the  actual  amount  of  current  liabilities. 
If  a  company  has  outstanding  large  amounts  of 
bills  and  notes  payable,  it  occupies  a  vulnerable 
position.  Inability  to  renew  maturing  notes 


INDUSTRIAL   BONDS  69 

was  the  cause  of  most  of  the  industrial  failures 
of  last  year. 

(r)  Net  Earnings.  The  amount  of  net  earn- 
ings is  of  great  importance  in  estimating  the 
strength  of  an  industrial  company.  The  figures 
for  a  number  of  years  should  be  examined  to 
determine  whether  the  earnings  are  increasing 
or  decreasing,  and  to  discover  whether  or  not 
the  earning  power  of  the  company  is  stable. 
This  will  depend  largely  upon  the  nature  of  the 
article  which  the  company  produces  or  trades 
in.  If  its  product  enjoys  a  steady  demand  at 
a  fairly  uniform  price,  it  is  justifiable  that  some 
of  its  capital  should  be  in  the  form  of  bonds; 
but  if  its  earnings  are  subject  to  violent  fluctua- 
tions due  to  rapid  changes  in  the  price  of  its 
product,  there  is  little  justification  for  conduct- 
ing the  business  on  borrowed  money. 

In  this  connection  it  should  always  be  con- 
sidered how  greatly  a  falling  off  in  gross  earn- 
ings will  affect  net  earnings;  and  the  propor- 
tion between  net  earnings  and  fixt  charges 
should  be  carefully  noted. 

In  order  for  an  industrial  bond  to  receive 
favorable  consideration,  the  average  yearly  net 
earnings  of  the  company  should  amount  to 


70       HOW   TO    INVEST    MONEY 

about  three  times  the  annual  bond  interest, 
taxes,  and  sinking  funds.  The  greater  the  pro- 
tection is  in  this  respect  the  better. 

(d)  Form  of  Issue.    The  form  in  which  an 
industrial  bond  is  issued  is  a  matter  of  some  im- 
portance.   If  the  principal  of  the  bond  does  not 
become  due  for  a  number  of  years,  there  is 
danger  that  the  property  will  depreciate  so  far 
in  value  as  to  leave  the  bond  without  sufficient 
margin  of  protection.    There  are  two  ways  to 
overcome  this  difficulty.    One  way  is  to  estab- 
lish a  sinking-fund  which  will  retire  a  certain 
proportion  of  the  bonds  by  lot  each  year.    An- 
other way  is  to  issue  the  bonds  in  serial  form, 
with  a  definite  instalment  maturing  every  year. 
In  either  case  the  annual  sinking-fund  or  an- 
nual  instalment  should  be  greater  than  the 
probable  depreciation  so  that  the  margin  of  se- 
curity will  be  constantly  increasing. 

(e)  Management  and  Control.  No  question 
is   of   greater   importance   in   estimating   the 
strength  of  an  industrial  company  than  the  rep- 
utation of  the  men   in  charge.     The  ability 
and   integrity   of   the   men   who   control   the 
policy  of  the  company  and  the  efficiency  of 
the  operating  officials  are  the  principal  factors 


INDUSTRIAL   BONDS  71 

in  the  success  of  an  industrial  undertaking. 
Vacillating  policies,  weakly  executed,  will  ruin 
the  most  promising  enterprise.  This  is  particu- 
larly true  in  the  case  of  small  companies.  Every 
man  of  business  experience  will  understand  the 
importance  of  this  factor  and  be  guided  by  it  in 
the  selection  of  industrial  securities. 

Based  upon  the  foregoing  considerations  it 
is  of  interest  to  inquire  what  degree  of  safety 
really  attaches  to  the  average  industrial  bond  ? 
How  far  does  it  meet  the  foregoing  require- 
ments ?  The  question  is  difficult  to  answer.  In- 
dustrial bonds  vary  greatly  in  point  of  safety, 
some  issues  possessing  great  strength  and  oth- 
ers being  highly  speculative.  No  general  con- 
clusions can  be  depended  upon,  and  the  investor 
is  forced  to  consider  each  issue  upon  its  own 
merits. 

II.  Rate  of  Income.    The  average  net  return 
upon  industrial  bonds  is  probably  higher  than 
upon  any  other  form  of  funded  corporate  obli- 
gation.    This  constitutes  one  of  the  chief  ad- 
vantages of  industrial  bonds. 

III.  Convertibility.    It  is  impossible  to  make 
any  general  statement  in  regard  to  the  convert- 
ibility of   industrial  bonds.     Some  industrial 


v*^^*v 

OF  THE  \ 

DIVERSITY  ) 

OF  J 


72       HOW   TO   INVEST   MONEY 

bonds,  notably  the  larger  issues  of  well-known 
trusts,  command  a  broad  and  active  market. 
Such  bonds  can  be  sold  in  large  amounts  at 
almost  any  time  without  seriously  affecting  the 
price.  On  the  other  hand,  small  underlying 
issues  of  such  companies,  usually  high-grade  in 
point  of  security,  or  the  obligations  of  smaller 
companies,  are  almost  as  unmarketable  as  real- 
estate  mortgages.  Between  these  two  extremes 
all  varieties  of  industrial  bonds  are  to  be  found. 
The  degree  of  convertibility  which  a  security 
possesses  is  usually  a  matter  of  some  import- 
ance, and  the  investor  should  make  a  careful  ex- 
amination of  each  bond  in  this  respect. 

IV.  Prospect  of  Appreciation  in  Value.  To 
what  extent  a  bond  may  improve  in  security 
during  the  time  that  an  investor  holds  it  is  of 
little  importance  unless  the  improvement  be  re- 
flected in  the  market  price  of  the  bond.  Only 
so  can  the  investor  take  advantage  of  its  appre- 
ciation in  value.  In  order  for  the  improvement 
in  security  to  be  reflected  in  market  price  and 
thus  add  to  the  principal  invested,  it  is  neces- 
sary that  a  bond  should  possess  a  fairly  active 
market.  For  this  reason  the  industrial  bonds 
which  hold  out  the  greatest  promise  of  appre- 


INDUSTRIAL    BONDS  73 

ciation  in  value  are  the  larger,  more  specula- 
tive issues,  which  possess  the  greatest  convert- 
ibility. The  purchase  of  such  bonds  frequently 
results  in  substantial  profits. 

V.  Stability  of  Market  Price.  The  four 
points  above  touched  upon — safety,  rate  of  in- 
come, convertibility,  and  likelihood  of  improve- 
ment in  intrinsic  value — are  all  inherent  char- 
acteristics of  every  bond.  The  likelihood  of 
favorable  or  unfavorable  fluctation  in  market 
price  is  largely  external  in  its  nature  and  de- 
pends upon  general  financial  and  business 
conditions. 

As  a  class,  industrial  bonds  can  not  be  said 
to  possess  much  stability  of  market  price. 
Some  of  the  smaller  issues  enjoy  a  fictitious 
stability  because  of  their  inactivity,  but  gen- 
erally speaking  industrial  bonds  are  subject  to 
wide  fluctations  in  accordance  with  changes  in 
the  business  outlook. 

The  foregoing  is  a  summary,  necessarily 
brief  and  imperfect,  of  the  main  points  to  be 
considered  in  judging  the  value  of  industrial 
bonds.  The  question  remains  whether  such 
securities  are  desirable  for  the  investment  of  a 
business  surplus  and  of  private  funds. 


74       HOW   TO    INVEST    MONEY 

Except  in  special  cases  industrial  bonds  are 
not  suitable  for  a  business  surplus.  It  is  im- 
possible to  find  an  industrial  bond  which  com- 
bines all  the  characteristics  necessary  for  that 
purpose.  The  requirements  are  great  safety 
of  principal  and  interest,  a  relatively  high  re- 
turn, ready  convertibility,  and  stability  of  mar- 
ket price.  Many  industrial  bonds  can  be  found 
which  combine  two  of  these  requirements, 
some  even  which  combine  three,  but  the  full 
combination,  if  it  exists  at  all,  is  unknown  to 
the  writer. 

In  addition,  the  principle  of  distribution  of 
risk  should  prevent  one  industrial  company 
from  investing  its  reserve  funds  in  the  securi- 
ties of  another  industrial  company. 

For  private  investment  the  case  is  somewhat 
different.  A  man  of  good  business  judgment, 
who  desires  to  obtain  a  high  yield  for  which 
he  is  prepared  to  sacrifice  something  in  the 
way  of  convertibility  and  prospect  of  apprecia- 
tion in  value,  may  buy  the  underlying  issues  of 
strong  companies  with  every  confidence  in  the 
safety  of  his  principal.  Again,  the  investor 
who  wants  a  high  yield  and  quick  convertibil- 
ity, who  is  prepared  to  take  a  business  man's 


INDUSTRIAL   BONDS  75 

risk  and  to  sacrifice  stability  of  market  price, 
may  make  a  large  profit  by  buying  second- 
grade  industrial  bonds.  No  investor,  however, 
should  deceive  himself  with  the  idea  that  any 
industrial  bond  will  satisfy  all  the  requirements 
of  the  ideal  investment. 


VI 


PUBLIC-UTILITY  BONDS 

IT  was  a  common  saying  among  bond-deal- 
ers a  few  years  ago  that  the  day  of  the 
municipal  bond  had  passed,  the  day  of  the  rail- 
road bond  was  passing,  and  the  day  of  the 
public-utility  bond  was  to  be.  Municipal  bonds 
were  selling  at  fancy  prices  in  consequence  of 
the  low  rates  for  money  which  then  prevailed, 
and  railroad  bonds  appeared  to  be  following  in 
their  wake.  Public-utility  bonds  alone  afforded 
a  satisfactory  yield,  and  it  was  felt  that  the 
investing  public  would  be  forced  to  turn  to 
them. 

This  prediction,  like  many  others  which 
were  based  upon  the  assumption  of  continued 
ease  in  money,  was  destined  to  be  unfulfilled. 
Almost  immediately  there  appeared  an  added 
demand  for  capital,  and  in  the  face  of  this 
demand,  supplies  of  capital  which  had  before 
seemed  ample  became  suddenly  scarce.  Money 

rates  rose  rapidly  and  as  a  necessary  conse- 
76 


PUBLIC-UTILITY    BONDS         77 

quence  municipal  and  railroad  bonds  fell  in 
price  to  a  point  where  their  net  return  was 
commensurate  with  that  obtained  from  the 
loaning  of  free  capital.  The  investment  situa- 
tion was  thus  completely  reversed.  It  was  no 
longer  a  question  as  to  what  form  of  security 
investors  must  seek  in  order  to  obtain  a  satis- 
factory yield,  but  rather  could  the  highest 
grade  of  municipal  and  railroad  bonds  be 
floated  at  any  price.  Under  these  circum- 
stances the  contemplated  necessity  of  turning 
to  public-utility  bonds  never  arose,  and  the  gen- 
eral investing  public  remains  for  the  most  part 
unfamiliar  with  their  elements  of  strength  and 
of  weakness. 

The  term  "public-utility  company"  denotes  a 
private  corporation  supplying  public  needs  un- 
der authority  of  a  public  franchise.  The  fran- 
chise may  be  of  definite  date  or  perpetual,  and 
may  be  partial  or  exclusive. 

Public-utility  companies  include  street-rail- 
way, gas,  electric-light  and  power,  and  water 
companies.  Properly  speaking,  telephone  com- 
panies should  also  be  included,  but  they  are  not 
usually  regarded  as  belonging  to  the  class  of 
public-service  corporations. 


78       HOW   TO    INVEST    MONEY 

It  is  impossible,  within  the  limits  of  a  single 
chapter,  to  discuss  each  kind  of  company  sep- 
arately. The  investment  value  of  street-rail- 
way bonds  will  be  here  considered,  and  it  is  felt 
that  the  general  principles  advanced, with  slight 
modifications  of  detail,  will  be  found  equally 
applicable  to  a  judgment  of  other  forms  of  pub- 
lic-service securities. 

I.  Safety  of  Principal  and  Interest.  In 
order  to  determine  the  safety  of  a  street-rail- 
way company's  bonds,  the  company  must  be 
subjected  to  a  threefold  examination,  physical, 
financial,  and  political. 

An  examination  must  be  made  into  the 
extent  and  condition  of  the  physical  property 
in  order  to  ascertain  whether  the  bonded  debt 
is  secured  by  property  having  a  real  market 
value  in  excess  of  the  face  amount  of  bonds 
issued.  The  first  point  to  be  determined  is  the 
extent  and  valuation  of  the  company's  real 
estate.  If  the  appraised  value  of  the  land  upon 
which  power-houses  and  car-barns  have  been 
erected  is  alone  greater  than  the  amount  of 
bonds  outstanding,  the  investigation  need  go 
no  further,  for  the  bonds,  in  such  a  case,  would 
be  practically  a  real-estate  mortgage.  In  most 


PUBLIC-UTILITY    BONDS         79 

instances,  however,  this  is  very  far  from  being 
the  case ;  and  after  careful  appraisal  of  the  real 
estate  it  is  then  necessary  to  make  a  careful 
valuation  of  the  other  physical  property; 
namely,  power-plants,  depots,  car-sheds,  road- 
way, and  equipment. 

It  is  usually  impossible  for  the  average  in- 
vestor to  make  such  an  examination  himself, 
nor  is  it  likely  that  he  would  possess  sufficient 
technical  knowledge  to  render  his  investigation 
of  much  value.  For  an  accurate  estimate  of 
the  value  of  a  street-railway's  physical  prop- 
erty, it  is  usually  necessary  to  depend  upon  the 
expert  opinion  of  a  trained  engineer.  It  is  a 
matter  of  regret  that  the  average  street-rail- 
way report  can  not  be  relied  upon  to  furnish  an 
accurate  valuation  of  the  physical  property; 
and  it  is  accordingly  customary  for  careful 
bond-dealers,  when  they  contemplate  taking  an 
issue  of  street-railway  bonds  for  distribution 
among  their  clients,  to  have  the  property  ex- 
amined by  a  competent  engineer,  whose  report 
then  determines  for  them  the  question  of  tak- 
ing the  issue. 

Disregarding  the  figures  which  show  the 
cost  of  property  and  equipment  upon  the  com- 


80       HOW   TO    INVEST    MONEY 

pany's  books,  the  engineer  proceeds  to  make  a 
careful  estimate  of  the  replacement  value  of 
the  property,  including  real  estate.  If  the  re- 
sult of  the  examination  shows  that  the  prop- 
erty could  not  be  duplicated  for  the  amount  of 
the  bond  issue,  the  company  occupies  an  unusu- 
ally strong  position — altho  even  in  such  a  case 
some  part  of  the  value  of  the  bonds  comes  from 
the  strength  of  the  company  as  a  going  con- 
cern. 

In  most  cases,  however,  it  is  probably  found 
that  the  bond  issue  is  in  excess  of  the  value 
of  real  estate  and  the  replacement  value  of  the 
physical  property,  the  balance  representing  a 
capitalization  of  the  franchise. 

To  determine  the  real  value  of  the  franchise 
or  franchises  is  a  difficult  matter  and  involves 
the  whole  question  of  the  company's  relations 
with  the  community  which  it  serves  and  with 
the  local  lawmaking  bodies. 

The  first  question  which  arises  is  whether 
the  franchise  is  perpetual  or  for  a  definite  time, 
and  the  second  whether  it  is  partial  or  exclu- 
sive. Franchises  vary  greatly  in  these  respects. 
Sometimes  a  franchise,  apparently  partial,  is 
practically  exclusive,  owing  to  the  fact  that  all 


PUBLIC-UTILITY    BONDS         81 

the  available  space  in  the  streets  is  already 
occupied  by  the  company's  own  tracks.  If  the 
franchises  of  a  company  are  limited  as  to  time, 
it  is  expedient,  if  not  imperative,  that  the  bonds 
should  mature  before  the  expiration  of  the 
franchises. 

If  the  company  whose  bonds  are  under  ex- 
amination satisfactorily  passes  this  physical 
test — if  it  possesses  real  estate  of  considerable 
value,  if  the  replacement  value  of  the  property 
is  as  great  or  nearly  as  great  as  the  amount  of 
the  bonds,  and  if  the  franchises,  while  perhaps 
not  perpetual  or  exclusive,  are  yet  of  longer 
duration  than  the  bonds  and  render  successful 
competition  unlikely — the  next  step  may  then 
be  taken;  that  is  to  say,  an  examination  of  the 
company's  financial  condition  and  earning 
capacity  may  be  made. 

The  amount  of  its  gross  earnings  should  be 
examined  and  the  figures  scrutinized  for  a 
number  of  years  back  to  discover  whether  its 
earnings  are  increasing  or  decreasing.  The 
position  in  which  the  company  stands  for  ob- 
taining new  traffic  must  be  noted,  and  some 
estimate  must  be  made  of  the  stability  of  its 
earning  power.  In  this  connection  the  rela- 


82       HOW   TO    INVEST    MONEY 

tions  of  the  company  to  the  public  are  of  great 
importance.  It  must  be  learned  whether  the 
company  follows  the  policy  of  conciliating  or 
ignoring  public  sentiment. 

The  net  earnings  of  the  company  must  then 
be  examined.  This  involves  a  criticism  of 
operating  expenses.  The  payments  of  the  road 
must  be  analyzed  to  determine  whether  the 
proper  amounts  have  been  expended  for  re- 
newal of  track,  replenishment  of  rolling  stock, 
and  other  improvement  sufficient  to  keep  the 
property  in  good  physical  condition.  This  is 
the  most  intricate  subject  in  the  investigation 
of  a  street-railway  property.  Unless  proper 
allowance  be  made  for  depreciation,  in  addition 
to  the  expenses  of  direct  operation,  it  is  only 
a  question  of  time  before  the  strongest  company 
will  become  bankrupt. 

Deterioration  of  plant  and  equipment,  which 
goes  on  constantly,  can  only  be  offset  in  two 
ways:  one  is  out  of  earnings  and  the  other 
is  out  of  the  security-holders — that  is,  by  de- 
creases in  the  market  value  of  the  securities. 
The  first  takes  prosperity  or  courage;  the  sec- 
ond leads  to  bankruptcy.  It  is  difficult  to  meas- 
ure depreciation  accurately,  but  a  safe  rule  is 


PUBLIC-UTILITY    BONDS         83 

to  write  off  ten  per  cent  of  gross  earnings  each 
month  for  depreciation.  In  this  way  the  charge 
for  depreciation  will  be  proportionate  to  the 
traffic,  which  provides  automatic  adjustment. 

If  the  net  earnings,  after  making  this  allow- 
ance for  depreciation,  and  after  providing  all 
expenses  of  operation  including  ordinary  re- 
pairs, amount  to  as  much  as  twice  the  interest 
charges  upon  the  bonds  outstanding,  it  is  prob- 
able that  the  bonds  may  be  taken  with  safety. 

Before  finally  determining  the  question,  how- 
ever, certain  political  factors  must  be  taken 
into  consideration.  The  relations  of  the  com- 
pany to  the  leaders  of  the  dominant  political 
party  must  be  investigated.  The  likelihood  of 
agitation  looking  toward  a  reduction  of  fares 
must  be  considered  and  the  possibility  of  in- 
crease in  taxes  (if  below  the  legal  limit)  must 
be  weighed.  The  probable  attitude  of  the  legis- 
lature on  the  question  of  renewing  the  fran- 
chises when  they  expire  must  be  considered.  In 
general,  it  must  be  learned  whether  any  real 
ground  of  contention  exists  between  the  com- 
pany on  the  one  hand  and  the  public  and  its 
representatives  on  the  other,  because  it  is  inev- 
itable that  the  company  will  weaken  its  inde- 


84       HOW   TO    INVEST    MONEY 

pendence  of  position  by  too  close  a  connection 
with  politics,  and  that  the  physical  property 
will  suffer  if  there  is  any  lack  of  uninterrupted 
attention  to  it. 

Finally  one  other  thing  should  be  investigated 
— the  amount  of  the  accident  account  and  its 
proportion  to  the  net  earnings  of  the  company. 
On  small  lines  a  single  case  of  heavy  damages 
will  sometimes  make  serious  inroads  upon  the 
earnings. 

The  foregoing  is  a  summary,  necessarily 
brief  and  imperfect,  but  true  in  its  essential  out- 
lines, of  the  main  points  which  should  be  con- 
sidered in  judging  the  safety  of  street-railway 
bonds.  The  question  remains,  how  far  does  the 
average  street-railway  company  satisfy  these 
requirements?  Broadly  speaking,  street-rail- 
way bonds  are  not  yet  to  be  classed  in  the  first 
rank  of  investment  securities.  The  troubles 
which  have  come  to  a  head  in  the  financial 
operations  of  the  traction  systems  in  New  York 
and  Chicago  are  typical  of  troubles  which  are 
likely  to  occur  elsewhere  from  the  same  gen- 
eral causes — overcapitalization  in  the  first  place 
and  insufficient  allowance  for  depreciation  in 
the  second  place.  In  both  New  York  and  Chi- 


PUBLIC-UTILITY    BONDS         85 

cago  the  crisis  was  hastened  by  open  and  ob- 
vious overcapitalization,  which  is  almost  inevi- 
table when  many  independent  lines  are  merged 
into  one  system.  The  same  trouble,  however, 
is  apt  to  occur  in  other  traction  systems  where 
this  evil  appeared  less  flagrant  at  the  outset. 

The  advantages  of  electricity  over  horse- 
power naturally  led  to  the  multiplication  of 
electric  street  lines,  as  the  system  ten  or  fifteen 
years  ago  passed  beyond  the  experimental  stage. 
As  in  all  new  enterprises,  speculation  ran  ahead 
of  the  reality  and  financing  built  upon  oversan- 
guine  calculations  has  too  often  had  difficulty 
in  squaring  accounts  when  brought  face  to 
face  with  facts.  In  most  of  the  calculations  in- 
sufficient allowance  was  made  for  the  wear  and 
tear  of  service;  in  other  words,  for  renewal 
of  road  and  equipment.  After  a  few  years' 
test  of  earnings  against  expenses,  it  became 
evident  that  a  proper  allowance  for  deprecia- 
tion of  plant  would  show  a  heavy  deficit  in  the 
income  account.  In  most  cases  therefore  no 
allowance  or  only  a  meager  one  was  made. 
For  a  time  this  method  of  bookkeeping  proved 
less  disastrous  than  might  have  been  expected 
owing  to  the  rapid  growth  of  population  and 


86       HOW    TO    INVEST    MONEY 

business  in  American  cities.  It  was  possible  in 
many  cases  to  consider  the  enhanced  value 
given  to  the  franchise  by  growth  of  business 
as  an  offset  to  the  depreciation  of  tracks  and 
equipment.  In  so  far  also  as  the  plant  was 
kept  up  to  a  high  degree  of  efficiency  by  char- 
ging the  expense  of  repairs  to  operating  ex- 
penses, the  absence  of  a  depreciation  account 
was  partially  offset. 

With  the  progress  of  recent  years,  however, 
a  new  factor  has  been  entering  into  the  prob- 
lem which  promises  to  make  the  situation  still 
more  serious  for  the  traction  systems.  This 
new  factor  is  the  rise  in  prices  and  wages. 
Temporarily  the  influence  of  this  factor  may 
be  checked  by  diminished  business  activity,  but 
when  normal  conditions  are  restored,  it  will 
commence  to  act  again  upon  the  railways  with 
accumulated  effect. 

In  most  cases  a  proposition  to  increase  the 
standard  street-railway  fare  above  five  cents 
as  an  offset  to  the  increased  operating  expenses 
would  be  so  revolutionary  a  proposal  that  it 
could  hardly  be  carried  through.  With  the 
line  of  cost  converging  upon  the  line  of  receipts 
and  with  no  proper  allowance  made  for  depre- 


PUBLIC-UTILITY    BONDS         87 

ciation,  the  traction  systems  of  the  country 
seem  to  be  facing  a  difficult  problem.  In  the 
long  run  it  can  not  be  doubted  that  the  problem 
will  be  met  and  solved  in  a  way  to  afford  justice 
alike  to  the  public  who  use  the  cars  and  to  the 
capitalists  who  have  made  street  traction  on  a 
large  scale  possible,  but  in  the  meantime  the 
investor  who  desires  perfect  safety  should  ex- 
ercise great  care  and  discrimination  in  his  pur- 
chases of  street-railway  obligations. 

II.  Rate  of  Income.     As  a  general  rule, 
street-railway  bonds  in  common  with  the  obli- 
gations of  all  public-service  corporations  sell 
upon  about  the  same  income  basis  as  high- 
grade  industrial  bonds — that  is  to  say,  under 
normal    conditions    they    return    considerably 
more  than  railroad  or  municipal  bonds. 

III.  Convertibility.    It  is  difficult  to  speak 
of  the  convertibility  of  public-utility  bonds  as  a 
class  for  the  reason  that  they  differ  widely 
from  one  another  in  this  respect.    In  general,  it 
is  certainly  more  difficult  to  dispose  of  public- 
utility  bonds  than  railroad  bonds.    They  do  not 
possess  sufficient  convertibility  to  justify  their 
purchase  by  any  one  who  may  need  to  realize 
quickly  on  his  holdings. 


88       HOW   TO    INVEST    MONEY 

IV.  Prospect    of   Appreciation   in    Value. 
Public-utility  bonds,  except  such  issues  as  are 
convertible  into  stock,  possess  little  prospect  of 
appreciation   in   value.      It   was   pointed   out 
above  that  depreciation  is  not  properly  allowed 
for,  and  it  is  very  difficult  for  the  securities  to 
advance  in  the  face  of  this  obstacle. 

V.  Stability  of  Market  Price.     The  bonds 
of   public-service   corporations   are   relatively 
more  stable  than  railroad  bonds  because  their 
earnings   are  not   subject   to   the   fluctations 
which   occur   in   railroad   properties   between 
years  of  prosperity  and  years  of  depression.  At 
the  same  time,  it  should  be  pointed  out  that 
their  stability  of  price  is  largely  fictitious,  ow- 
ing to  the  comparative  inactivity  of  the  issues. 
In  other  words,  while  the  quotation  may  be 
maintained,  it  is  usually  difficult  to  sell  any 
large  quantity  of  a  public-service  corporation's 
bonds  in  a  period  of  financial  disturbance,  while 
railroad  bonds  are  more  easily  liquidated  even 
if  at  a  sacrifice. 

The  question  remains,  do  public-utility  bonds 
afford  a  desirable  security  for  the  investment 
of  a  business  surplus  and  of  private  funds  ?  In 
regard  to  the  former,  it  may  be  said  at  once 


PUBLIC-UTILITY    BONDS         89 

that  public-utility  bonds  do  not  meet  the  neces- 
sary conditions.  The  security  is  too  doubtful, 
the  convertibility  is  too  small,  and  the  stability 
of  price  too  uncertain. 

For  private  investment  the  case  is  somewhat 
different.  Keeping  in  mind  the  desirability  of 
diversifying  investments  and  admitting  the 
attractiveness  of  investing  in  a  class  of  prop- 
erty whose  earnings  are  comparatively  stable, 
it  seems  clear  that  public-utility  bonds  can  not 
be  dismissed  without  consideration.  When  a 
company  is  found  whose  property  is  substan- 
tially equal  in  real  value  to  its  bonded  debt, 
whose  allowance  for  depreciation  is  ample, 
whose  franchises  are  satisfactory,  whose  earn- 
ing capacity  is  large,  and  whose  management 
is  capable  and  upright,  the  investor  is  justified 
in  giving  careful  consideration  to  its  issues. 
Unless  all  these  points  are  found  to  be  satis- 
factory, however,  the  investor  should  content 
himself  with  some  other  form  of  security.  For 
some  years  to  come  it  is  to  be  feared  that  many 
of  our  public-service  corporations  will  suffer 
from  the  war  of  discordant  elements — disre- 
gard of  the  rights  of  the  public  on  the  part  of 
the  management  and  socialistic  agitation  for 


90       HOW   TO   INVEST   MONEY 

control  on  the  part  of  the  community.  Until 
these  warring  factions  are  reconciled  and  the 
questions  at  issue  adjusted  with  fairness  to  the 
security-holders  and  the  public,  the  investor 
should  be  most  prudent  in  his  purchases  of  pub- 
lic-utility obligations. 


VII 


MUNICIPAL  BONDS 

THE  previous  chapters  have  considered,  in 
turn,  the  investment  value  of  railroad 
bonds,  real-estate  mortgages,  industrial  bonds, 
and  public-utility  bonds.  The  desirability  of 
each  of  these  different  classes  of  security  has 
been  judged  in  accordance  with  the  general 
principles  laid  down  in  the  introductory  chap- 
ter ;  that  is  to  say,  each  class  has  been  analyzed 
in  relation  to  safety,  rate  of  income,  converti- 
bility, prospect  of  appreciation  in  value  and 
stability  of  market  price.  The  same  determin- 
ing factors  must  now  be  applied  to  a  judgment 
of  government,  State,  and  municipal  bonds. 

Bonds  issued  by  a  national  government,  by 
a  State,  or  by  a  municipality  are  based  prima- 
rily on  some  form  of  the  power  of  taxation,  tho 
the  bonds  are  usually  tax  exempt  within  the 
political  unit  which  creates  them. 

When  the  power  of  taxation  is  unlimited,  as 
in  the  case  of  the  national  government  and  the 

91 


92       HOW   TO    INVEST    MONEY 

sovereign  States,  there  can  be  no  question  as 
to  the  ability  of  the  political  unit  to  meet  its 
obligation,  and  the  question  becomes  entirely 
one  of  good  faith.  It  is  probable  that  the  obli- 
gations of  the  United  States  Government,  by 
reason  of  the  fact  that  the  per-capita  debt  of 
the  country  is  so  small,  the  wealth  of  the  coun- 
try so  great,  and  the  good  faith  of  the  Ameri- 
can people  so  clearly  established,  represent  the 
highest  type  of  security  to  be  found  in  the 
world.  It  is  quite  possible,  therefore,  that  the 
2-per-cent  United  States  Consols  would  sell  in 
any  case  at  a  relatively  higher  price  than  the 
obligations  of  any  other  country,  but  it  can  not 
be  denied  that  the  chief  reason  which  causes 
them  to  sell  at  the  remarkably  high  price  which 
they  have  attained  is  the  fact  that  they  are 
required  by  national  banks  as  security  for  cir- 
culation. This  fact  is  doubtless  the  controlling 
element  in  their  market  position,  and  at  once 
accounts  for  their  special  strength  and  removes 
them  from  the  field  of  private  investment. 

Only  less  secure  than  United  States  bonds 
are  the  obligations  of  the  sovereign  States  of 
the  Union.  State  bonds  usually  sell  upon  a 
basis  which  may  be  taken  as  the  equivalent  of 


MUNICIPAL    BONDS  93 

pure  interest,  with  no  element  of  risk  or  specu- 
lation involved.  The  obligations  of  different 
States  sell  at  different  prices,  in  accordance 
with  market  conditions  and  the  relations  of 
supply  and  demand,  but  there  can  be  no  ques- 
tion of  the  equal  ability  of  all  States  to  pay 
their  obligations.  Repudiation  of  State  debts 
has  occurred  in  our  history,  but  only  in  cases 
where  an  overwhelming  majority  of  the  citizens 
were  opposed  to  the  creation  of  the  debt  at  the 
time  of  its  issue,  but  lacked  the  means  to  con- 
trol the  situation.  Such  instances  are  chiefly 
to  be  found  in  the  case  of  the  so-called  carpet- 
bag governments  of  the  Southern  States  after 
the  Civil  War. 

Municipal  bonds — i.e.,  the  bonds  of  cities, 
counties,  and  townships — are  indirectly  a  first 
lien  upon  all  taxable  property  in  the  munici- 
pality, and  take  precedence  of  every  form  of 
mortgage  or  judgment  lien.  This  lien  is  en- 
forced through  a  tax  levy  to  meet  interest  and 
principal,  and  this  tax  levy  the  courts  will  com- 
pel in  the  rare  cases  in  which  a  municipality 
attempts  to  repudiate  a  valid  bond.  This  pri- 
ority of  the  tax  lien  is  the  foundation  of  the 
prime  position  of  municipal  bonds.  The  case 


94       HOW   TO    INVEST    MONEY 

rarely  occurs  where  a  bond  held  valid  by  the 
courts  proves  uncollectable  if  sufficient  taxing 
power  existed  when  the  bond  was  issued  to 
provide  for  its  redemption.  It  is  only  when 
the  municipality  itself  diminishes  in  popula- 
tion and  taxable  property  to  the  vanishing- 
point  that  such  a  default  can  occur.  An  in- 
vestor can  judge  for  himself  as  to  the  likeli- 
hood of  such  a  catastrophe  in  any  particular 
community,  and  can  feel  sure  that  his  bond,  if 
valid  and  protected  by  a  sufficient  taxing 
power,  is  as  secure  in  its  principal  and  interest 
as  the  municipality  which  issues  it  is  secure  in 
its  continued  existence.  The  following  are  the 
chief  points  which  should  be  considered  in  the 
investigation  of  a  municipal  bond:  (i)  The 
proportion  which  the  total  debt  of  the  munici- 
pality bears  to  the  assessed  valuation  of  the 
property  subject  to  taxation.  Usually  a  maxi- 
mum rate  is  fixt  by  constitutional  provision 
which  rarely  exceeds  10  per  cent.  (2)  The 
purpose  of  issue.  This  must  be  a  proper  and 
suitable  one.  (3)  The  proceedings  under 
which  the  bonds  were  issued.  These  proceed- 
ings, the  form  of  bonds,  their  execution,  and 
their  legal  details  must  be  in  full  compliance 
with  the  law. 


MUNICIPAL   BONDS  95 

If  these  points  are  found  to  be  satisfactory, 
the  investor  may  rest  content  that  no  other 
form  of  security  is  so  greatly  safeguarded  and 
that  his  bond  ranks  upon  a  substantial  equality 
with  government  and  State  obligations. 

The  rate  of  income  to  be  derived  from  invest- 
ment in  municipal  bonds  varies  in  accordance 
with  the  obligations  selected.  Like  other  forms 
of  security,  municipal  bonds  are  controlled  by 
market  conditions,  and  their  price  is  deter- 
mined by  the  relations  of  supply  and  demand, 
and  by  adjustment  to  prevailing  money  rates. 
While  differing  only  moderately  from  one  an- 
other in  point  of  safety  and  income  return, 
municipal  bonds  may  be  divided  into  two  dis- 
tinct classes  in  accordance  with  the  degree  of 
convertibility  which  they  possess.  Some  mu- 
nicipal bonds  possess  great  convertibility; 
others  almost  none.  The  feature  which  chiefly 
determines  the  activity  or  inactivity  of  a  munic- 
ipal issue  is  the  size  and  importance  of  the  mu- 
nicipality, together  with  the  amount  of  bonds 
which  it  has  outstanding.  The  bonds  of  large 
and  important  cities,  whose  outstanding  debt 
reaches  considerable  proportions,  usually  pos- 
sess great  activity.  They  are  constantly  traded 


96       HOW   TO    INVEST    MONEY 

in  and  command  a  broad  market  because  deal- 
ers are  willing  to  buy  or  sell  them  in  blocks 
at  prices  within  a  fraction  of  i  per  cent  apart. 

On  the  other  hand,  the  bonds  of  counties, 
townships,  and  small  cities  are  usually  quite 
inactive.  Transactions  rarely  occur  in  them, 
dealers  do  not  make  a  market  in  them,  and  they 
can  be  sold  only  to  genuine  investors.  It  is 
often  impossible  to  have  them  even  quoted. 

At  first  sight,  it  would  appear  that  active 
municipal  bonds  would  be  much  more  desirable, 
but  inactive  municipals  possess  a  special  ad- 
vantage which  the  active  ones  do  not  enjoy. 
They  possess  more  stability  of  market  price. 
It  is  true  that  their  stability  of  value  is  due  to 
the  fact  that  they  are  not  traded  in  or  quoted 
and  is,  therefore,  largely  fictitious,  but  never- 
theless it  accomplished  a  useful  purpose.  It 
enables  the  investor  to  carry  inactive  munici- 
pals at  cost  price  upon  his  books  through  peri- 
ods in  which  active  market  bonds  would  re- 
quire to  be  marked  down  in  conformity  with 
prevailing  market  prices.  No  other  class  of 
investment  except  real-estate  mortgages  pos- 
sesses to  the  same  degree  this  quality  of  price 
stability.  For  many  classes  of  buyers — sa- 


MUNICIPAL   BONDS  97 

vings-banks,  for  example — stability  of  price  is 
a  consideration  of  prime  importance.  The 
preservation  of  the  savings-bank's  surplus  and, 
indeed,  the  continued  solvency  of  the  institution 
depend  upon  maintaining  the  integrity  of  the 
principal  which  it  has  invested.  A  savings- 
bank  requires,  also,  great  safety  of  principal 
and  interest;  i.e.,  the  certainty  that  principal 
and  interest  instalments  will  be  paid  at  ma- 
turity. It  needs  only  a  fair  but  not  high  yield, 
and  it  does  not  need  to  place  emphasis  upon 
convertibility  or  prospect  of  appreciation  in 
value.  Comparison  of  these  requirements  with 
the  characteristics  of  inactive  municipal  bonds 
discloses  a  striking  adaptability  on  their  part 
to  the  real  needs  of  the  case.  As  a  consequence, 
it  is  not  surprizing  to  discover  that  inactive 
municipals  are  greatly  sought  by  savings- 
banks. 

The  desirability  of  inactive  municipals  for 
savings-bank  investment  was  never  more  for- 
cibly illustrated  than  on  the  first  of  last  January, 
when  the  savings-banks  came  to  make  up  their 
annual  statements.  Broadly  speaking,  there 
can  be  no  doubt  that  they  were  saved  by  the 
large  quantity  of  inactive  municipals  and  real- 


98       HOW   TO    INVEST    MONEY 

estate  mortgages  which  they  carried.  Had  any 
considerable  portion  of  their  assets  consisted 
of  railroad  bonds  and  active  municipals,  upon 
which  they  should  have  had  to  write  off  a  loss 
of  ten  to  fifteen  points,  their  solvency  would 
almost  certainly  have  been  impaired. 

But  we  are  chiefly  concerned  in  these  pages 
with  the  advantages  and  disadvantages  of  dif- 
ferent forms  of  investment  from  the  point  of 
view  of  a  business  man,  both  for  the  invest- 
ment of  his  business  surplus  and  of  his  private 
funds.  Do  municipal  bonds,  either  active  or 
inactive,  conform  to  the  requirements  of  the 
business  surplus  ?  It  can  not  be  said  that  they 
do.  Municipal  bonds  possess  either  converti- 
bility without  stability  of  price  or  stability  of 
price  without  convertibility.  Both  qualities  are 
necessary  for  a  business  surplus.  The  only 
form  of  municipal  security  which  is  at  all 
adapted  for  the  investment  of  a  business  sur- 
plus is  a  shQrj^termjssue,  pi  an  active  munici- 
pal bond.  If  it  has  only  a  very  few  years  to  run, 
its  constant  approach  to  maturity  will  invest  it 
with  the  necessary  stability  of  price.  But  even 
in  this  case  equal  safety  and  equal  stability  of 
price  combined  with  a  higher  yield  can  proba- 


MUNICIPAL    BONDS  99 

bly  be  found  in  some  high-grade  railroad  issue 
— either  a  short-term  mortgage  or  equipment 
bond. 

For  private  investment  the  case  is  somewhat 
different.  Enough  has  been  said  in  the  pre- 
ceding chapters  to  impress  upon  the  reader  the 
importance  of  buying  securities  only  in  accord- 
ance with  his  real  requirements.  If  any  in- 
vestor, after  careful  comparison  of  the  char- 
acteristics of  municipal  bonds,  either  active  or 
inactive,  with  his  necessities,  decides  that  he 
can  more  closely  satisfy  his  requirements  with 
municipals  than  with  any  other  form  of  secu- 
rity, he  should  not  hesitate  to  purchase  them. 
It  is  the  opinion  of  the  writer,  however,  that 
a  thorough  survey  of  the  field  of  investment 
will  generally  disclose  to  the  investor  some 
security  in  either  the  railroad  or  corporation 
field  which  will  suit  his  requirements  as  well 
as  the  municipal  bond  and  at  the  same  time 
provide  him  with  a  greater  income. 


VIII 

STOCKS 

OASSING  to  the  consideration  of  stocks  as 
*  investments,  it  is  necessary  at  the  outset 
that  the  reader  should  have  clearly  in  mind  the 
fundamental  difference  between  stocks  and 
bonds.  This  distinction  was  drawn  in  the  in- 
troductory chapter,  but  it  will  be  well  to 
amplify  it  here,  even  at  the  risk  of  carrying 
the  reader  over  familiar  ground. 

The  distinction  between  bonds  and  stocks  is 
that  between  promises  to  pay  and  equities. 
Bonds,  loans  on  collateral,  and  real-estate  mort- 
gages represent  some  one's  promise  to  pay  a 
sum  of  money  at  a  future  date;  and  if  the 
promise  be  valid  and  the  security  ample,  the 
holder  of  the  promise  will  be  paid  the  money 
on  the  date  due.  Stocks,  on  the  other  hand, 
represent  only  a  beneficial  interest  or  residuary 
share  in  the  assets  and  profits  of  a  working 
concern  after  payment  of  its  obligations  and 


100 


STOCKS  101 

fixt  charges.  The  value  of  the  residuary  share 
may  be  large  or  small,  may  increase  or  dimin- 
ish, but  in  no  case  can  the  holder  of  such  a 
share  require  any  one,  least  of  all  the  company 
itself,  to  take  his  share  off  his  hands  at  the 
price  he  paid  for  it,  or,  indeed,  at  any  price. 
If  a  man  buys  a  $1,000  railroad  bond,  he  knows 
that  the  railroad,  if  solvent,  will  pay  him  $1,000 
in  cash  when  the  bond  matures,  but  if  he  buys 
a  share  of  railroad  stock  his  only  chance  of 
getting  his  money  back,  if  he  should  wish  it, 
is  that  some  one  else  will  want  to  buy  his  share 
from  him  at  the  price  he  paid  for  it  or  more. 
If  he  buys  a  bond  he  becomes  a  creditor  of  the 
company,  without  voice  in  its  management,  but 
entitled  to  receive  his  principal  and  interest 
when  due  under  pain  of  forfeiture  of  the  secu- 
rity which  the  company  made  over  to  the  trustee 
to  insure  payment.  If  he  buys  stock,  he  be- 
comes a  partner  in  a  business  enterprise,  exer- 
cising his  proportionate  share  in  the  direction 
of  the  company's  affairs,  and  sharing  ratably 
in  its  profits  and  losses.  In  the  one  case  he 
buys  a  promise  to  pay  and  in  the  other  an 
equity. 

This    distinction,     which     appears     plainly 


102     HOW   TO   INVEST   MONEY 

marked  in  theory,  has  been  much  obscured  in 
recent  years  by  the  influence  of  two  factors. 
As  the  country  grew  in  size,  the  large  corpora- 
tions— the  railroads,  for  example — required 
greater  capital  in  order  to  provide  facilities  for 
the  handling  of  their  growing  business.  It  was 
impossible  to  provide  this  capital  wholly  by 
means  of  bond  issues  without  destroying  the 
proportion  between  bonds  and  stocks,  which 
alone  could  give  to  the  bondholders  the  protec- 
tion of  a  substantial  equity.  It  was  therefore 
necessary  to  obtain  a  large  part  of  the  capital 
required  in  the  form  of  stock.  The  railway- 
managers  were  thus  confronted  with  a  difficult 
problem.  It  was  imperative  that  they  should 
obtain  more  capital,  and  it  was  impossible  to 
dispose  of  sufficient  stock  on  the  basis  of  a  spec- 
ulative risk  in  a  business  venture.  It  was  there- 
fore necessary  for  the  railway-managers  to 
emphasize,  as  far  as  possible,  the  investment 
character  of  their  stock,  and  various  expedients 
were  adopted  to  accomplish  this  purpose.  In 
some  cases  preferred  stocks  were  created  or  re- 
sulted from  reorganizations,  which  possest  a 
first  lien  upon  the  assets  after  payment  of  the 
obligations,  and  which  were  entitled  to  a  cer- 


STOCKS  103 

tain  stipulated  dividend  before  the  common 
stock  obtained  any  distribution  from  the  earn- 
ings. In  this  way  the  railway-managers 
created  a  compromise  security  which  could  be 
regarded  as  a  stock,  and  would  thus  provide 
equity  from  the  bondholders'  point  of  view, 
and,  at  the  same  time,  one  which  could  be  dis- 
posed of  to  investors.  In  other  cases,  which 
were  probably  more  numerous,  railway-man- 
agers attempted  to  give  their  stock  an  invest- 
ment value  through  stability  of  income  return. 
In  good  years  when  the  company  earned  10  or 
15  per  cent  on  its  stock,  their  policy  was  to  pay 
only  5  or  6  per  cent  in  dividends,  and  hold  the 
rest  in  their  surplus  fund  in  order  to  have  the 
means  of  paying  the  same  dividends  the  next 
year  if  only  2  or  3  per  cent  should  be  earned. 
By  giving  their  stock  stability  of  income  return 
they  hoped  and  expected  to  give  it  some  stabil- 
ity of  market  price,  and  thus  make  it  attractive 
to  genuine  investors.  The  effect  of  this  policy 
was  unquestionably  successful,  and  one  after 
another  the  stocks  of  our  more  important 
transportation  systems  and  other  large  under- 
takings passed  into  the  hands  of  investors. 
The  successful  adoption  of  this  policy  on  the 


104     HOW   TO    INVEST    MONEY 

part  of  the  railway-managers  and  other  cap- 
tains of  industry  has  had  one  curious  effect 
which  was  not  contemplated  by  the  originators 
of  the  movement,  and  which  brings  us  to  the 
second  influence  mentioned  above  as  having 
tended  to  obscure  the  distinction  between  bonds 
and  stocks.  When  a  case  has  been  brought  be- 
fore the  courts  in  which  the  contention  was 
advanced  that  the  charges  of  the  railway  or 
public-service  corporation  were  too  high,  the 
courts  appear  to  have  taken  the  ground  that 
stocks  and  bonds  should  be  classed  together  in 
order  to  determine  the  aggregate  capitalization 
of  the  company,  and  that  the  justice  or  injus- 
tice of  the  contention  that  the  charges  are  too 
high  should  be  determined  by  ascertaining 
whether  if  the  charges  were  made  lower  the  net 
earnings  would  still  be  sufficient  to  pay  a  fair 
return  on  the  total  capital  invested.  This  is  the 
general  line  of  reasoning  pursued  by  the  courts, 
both  in  the  case  of  the  Consolidated  Gas  Com- 
pany in  New  York  and  the  Pennsylvania  Rail- 
road in  Pennsylvania.  The  effect  of  this  atti- 
tude on  the  part  of  the  courts  has  been  to 
obscure  still  more  greatly  the  real  distinction 
between  bonds  and  stocks.  It  is  too  early  as 


STOCKS  105 

yet  to  judge  what  will  be  the  final  outcome  of 
the  changed  attitude  toward  stocks,  but  it  can 
not  be  doubted  that  the  present  tendency  of 
opinion  on  the  subject,  so  far  as  large  corpora- 
tions are  concerned,  is  to  limit  the  return  on 
stocks  to  a  strictly  investment  basis,  instead  of 
leaving  the  stockholders  free  to  reap  all  possi- 
ble profit  from  their  business  venture  subject 
to  the  restraints  of  competition. 

The  adoption  of  this  attitude  by  the  courts 
should  be  a  matter  for  serious  consideration 
on  the  part  of  present  and  prospective  stock- 
holders. If  the  maximum  return  on  stock  is 
to  be  limited  to  6  per  cent,  or  any  fair  invest- 
ment basis,  and  charges  reduced  to  consumers 
so  that  they  obtain  the  benefit  of  any  greater 
earning  power,  it  would  appear  that  the  stock- 
holders occupy  an  undesirable  position.  With 
their  possible  profits  limited,  but  with  no  fixt 
return  insured  to  them  and  no  guaranty 
against  possible  loss,  it  can  not  be  held  that  the 
purchase  of  stock  seems  attractive. 

These  questions,  however,  will  doubtless  be 
settled  in  the  long  run  in  justice  both  to  the 
public  and  to  the  stockholders,  and  in  the  mean- 
time the  stocks  of  our  large  and  successful  rail- 


106     HOW   TO    INVEST   MONEY 

way  and  industrial  corporations,  which  have 
attained  a  certain  stability  and  permanence  of 
value,  are  entitled  to  consideration  when  invest- 
ments are  contemplated.  It  is  not  worth  while 
to  lay  down  rules  for  judging  the  investment 
value  of  such  stocks,  because  the  general  princi- 
ples advanced  in  the  preceding  chapters  will  be 
found  sufficient  for  a  judgment  of  their  values. 
One  class  of  stocks,  however,  deserves  spe- 
cial mention.  Bank  and  trust-company  stocks 
possess  one  characteristic  in  higher  degree  than 
other  classes  of  stock.  Owing  to  the  general 
practise  of  self-regulated  banking  institutions 
to  distribute  only  about  one-half  their  earnings 
in  dividends  and  to  credit  the  rest  to  surplus 
account,  a  steady  rise  is  assured  in  the  book 
value  of  the  stock.  No  other  class  of  stock  pos- 
sesses quite  the  same  promise  of  appreciation 
in  value.  Bank  and  trust-company  stocks  are 
especially  sought  by  wealthy  men,  who  can 
forego  something  in  the  way  of  income  return 
for  the  sake  of  increasing  the  amount  of  their 
principal.  The  general  characteristics  of  bank 
stocks  are  great  safety,  a  low  rate  of  income, 
limited  convertibility,  and  practical  certainty  of 
appreciation  in  value. 


STOCKS  107 

With  the  present  chapter  the  discussion  of 
specific  forms  of  investments  has  come  to  an 
end.  The  next  and  concluding  chapter  will  ex- 
plain the  general  principles  which  control  the 
market  movements  of  all  negotiable  securities, 
and  will  endeavor  to  point  out  the  indications 
which  may  be  relied  upon  in  determining 
whether  or  not  given  conditions  are  favorable 
for  the  purchase  of  securities. 


IX 


MARKET  MOVEMENTS  OF  SECURITIES 

THERE  is  no  question  connected  with  the 
investment  of  money  more  important  than 
the  ability  to  judge  whether  general  market 
conditions  are  favorable  for  the  purchase  of 
securities. 

After  learning  how  to  judge  the  value  of 
every  form  of  investment,  a  man  may  still  be 
unsuccessful  in  the  investment  of  money  unless 
he  acquires  also  a  firm  grasp  upon  the  general 
principles  which  control  the  price  movements 
of  securities.  By  this  it  is  not  meant  that  a 
man  needs  to  have  an  intimate  knowledge  of 
technical  market  conditions  whereby  to  esti- 
mate temporary  fluctations  of  minor  impor- 
tance, but  rather  that  he  should  have  clearly  in 
mind  the  causes  which  operate  to  produce  the 
larger  swings  of  prices.  If  an  investor  acquires 
such  a  knowledge,  he  is  enabled  to  take  ad- 
vantage of  large  price  movements  in  such  a 
way  as  materially  to  increase  his  income,  and, 

108 


MOVEMENTS    OF    SECURITIES    109 

at  the  same  time,  avoid  carrying  upon  his  books 
securities  which  may  have  cost  much  more  than 
their  current  market  quotations.  If  he  can 
recognize  the  indications  which  point  to  the 
beginning  of  a  pronounced  upward  swing  in 
securities,  and  if  he  can  equally  recognize  the 
signs  which  indicate  that  the  movement  has 
culminated,  he  can  liquidate  the  securities  which 
he  bought  at  the  inception  of  the  rise  or  trans- 
fer them  to  some  short-term  issues  whose  near 
approach  to  maturity  will  render  them  stable 
in  price,  allowing  the  downward  swing  to  pro- 
ceed without  disturbing  him.  It  is  not  ex- 
pected, of  course,  that  the  average  business  man 
will  be  able  to  realize  completely  this  ideal  of 
investment,  but  it  is  hoped  that  the  following 
anaylsis  will  give  him  a  clearer  conception  of 
the  principles  involved. 

Broadly  speaking,  the  market  movements  of 
all  negotiable  securities  are  controlled  by  two 
influences,  sometimes  acting  in  opposition  to 
each  other  and  sometimes  in  concert.  One  of 
these  influences  is  the  loaning  rate  of  free  capi- 
tal ;  the  other  is  the  general  condition  of  busi- 
ness. A  low  rate  of  interest  or  the  likelihood 
of  low  rates  has  the  effect  of  stimulating  secu- 


no     HOW   TO    INVEST    MONEY 

rity  prices,  because  banks  and  other  money-lend- 
ing institutions  are  forced  into  the  investment 
market  when  they  can  not  loan  money  to  ad- 
vantage. Conversely,  a  high  rate  of  interest 
or  the  prospect  of  high  rates  has  the  effect  of 
depressing  prices,  because  banking  institutions 
sell  their  securities  in  order  to  lend  the  money 
so  released.  The  automatic  working  of  this 
process  tends  to  produce  a  constant  adjustment 
between  the  yields  upon  free  and  invested  capi- 
tal. When  money  rates  are  low,  securities  tend 
to  advance  to  the  point  where  the  return  upon 
them  is  no  greater  than  that  derived  from  the 
loaning  of  free  capital.  When  rates  are  high, 
securities  tend  to  decline  to  a  point  where  the 
return  is  as  great.  This  explains  the  influence 
of  the  first  factor. 

The  other  factor  is  the  general  condition  of 
business  Good  business  conditions,  or  the 
promise  of  good  conditions,  tend  to  advance 
security  prices,  because  they  indicate  larger 
earnings  and  a  stronger  financial  condition. 
Poor  business  conditions,  or  an  unpromising 
outlook,  have  the  reverse  effect. 

The  larger  movements  of  security  prices  are 
always  the  resultant  of  the  interaction  of  these 


MOVEMENTS   OF   SECURITIES   in 

two  forces.  When  they  work  together  the 
effect  is  irresistible,  as  when  low  interest  rates 
and  the  prospect  of  good  business  conditions 
occur  together,  or  when  high  money  rates 
occur  in  the  face  of  an  indicated  falling  off  in 
business  activity.  At  such  times  all  classes  of 
securities  swing  together.  For  the  most  part, 
however,  money  rates  and  business  conditions 
are  opposed  in  their  influence,  rates  being  low 
when  business  is  bad  and  high  when  business 
is  good.  Usually  the  worse  business  conditions 
become,  the  easier  money  grows;  while  the 
more  active  business  becomes,  the  higher 
money  rates  rise.  The  effect  of  this  antagonism 
between  the  controlling  causes  is  to  produce 
movements  of  different  proportions  and  some- 
times in  different  directions  in  different  classes 
of  securities.  High-grade  bonds  may  be  decli- 
ning, middle-grade  bonds  remaining  stationary, 
and  poor  bonds  advancing,  all  at  the  same  time. 
This  serves  to  give  a  very  irregular  appearance 
to  the  security  markets,  and  appears  to  justify 
the  widely  held  opinion  that  security  prices  are 
a  pure  matter  of  guesswork,  and  that  they  are 
controlled  only  by  manipulation  and  special  in- 
fluences. A  clear  conception  of  the  nature  of 


ii2     HOW   TO    INVEST    MONEY 

the  influences  which  are  always  silently  at  work 
reconciles  these  apparent  inconsistencies  and 
makes  it  plain  that  general  price  movements 
are  determined  by  laws  as  certain  in  their 
operation  as  the  laws  of  nature. 

This  may  be  illustrated  by  a  single  example. 
Let  us  assume  that  interest  rates  are  low  and 
business  conditions  bad  with  prospect  of  still 
lower  interest  rates*  and  still  more  unpromising 
business  conditions.  What  will  be  the  effect 
upon  different  classes  of  securities?  High- 
grade  bonds,  such  as  choice  municipals,  whose 
safety  can  not  be  impaired  by  any  extent  of  de- 
pression in  business,  will  advance  because  their 
market  price  is  influenced  almost  wholly  by 
money  rates.  If  their  interest  is  certain  to  be 
paid,  no  matter  what  business  conditions  may 
become,  they  can  not  be  greatly  affected  by  a 
reduction  of  earnings,  and  consequently  the  in- 
fluence of  low  money  rates  is  left  to  act  prac- 
tically alone.  Middle-grade  bonds,  such  as  sec- 
ond-class railroad  issues,  will  remain  almost 
stationary,  low  money  rates  tending  to  advance 
their  price  and  the  fear  of  decreased  earnings 
tending  to  depress  them.  The  lowest  grade  of 
bonds  and  stocks,  whose  margin  of  security 


MOVEMENTS    OF   SECURITIES    113 

even  in  good  times  is  not  very  great,  will  prob- 
ably suffer  in  price  because  the  fear  of  default 
in  interest  and  of  reduction  in  dividends  will 
operate  much  more  strongly  than  the  mere 
stimulus  of  low  interest  rates.  Of  course, 
securities  can  not  be  clearly  separated  into  these 
three  classes,  but  shade  imperceptibly  into  one 
another.  The  classification  is  adopted  only  for 
purposes  of  illustration. 

Up  to  this  point  we  have  been  concerned 
merely  in  showing  that  the  market  movements 
of  negotiable  securities  are  controlled  by  the  in- 
fluence of  certain  factors.  A  more  important 
question  now  remains  to  be  considered,  viz.: 
whether  the  effect  of  these  two  influences  is  to 
produce  general  swings  in  prices  which  may  be 
depended  upon  with  comparative  certainty,  and, 
if  so,  what  indications  are  afforded  to  the  in- 
vestor of  the  commencement  or  culmination  of 
such  a  movement.  The  answer  must  be  that 
the  combined  effect  of  the  two  influences  de- 
scribed is  to  produce  definite  and  regular 
swings  in  prices,  and  that  the  indications  which 
define  the  movements  are  not  difficult  to  follow. 

A  general  survey  of  the  history  of  every 
industrial  nation  reveals  the  fact  that  business 


ii4     HOW   TO    INVEST    MONEY 

conditions  undergo  alternate  periods  of  pros- 
perity and  depression  extending  in  clearly  de- 
fined cycles  of  substantially  uniform  length.  By 
tracing  the  usual  course  of  interest  rates  and 
of  business  conditions  throughout  one  of  these 
cycles,  a  general  idea  can  be  formed  of  the  way 
in  which  the  joint  influences  operate  to  produce 
price  movements.  To  what  extent  the  course 
of  interest  rates  is  a  cause  as  well  as  a  result 
of  changing  business  conditions,  we  shall  not 
attempt  here  to  estimate,  but  will  be  content  to 
note  carefully  the  general  course  which  rates 
for  money  pursue  throughout  the  cycles.  Im- 
mediately after  a  financial  crisis,  which  usually 
closes  an  era  of  great  business  prosperity, 
money  rates  become  abnormally  easy.  Within 
a  few  months  from  the  climax  of  the  crisis, 
money  accumulates  in  enormous  volume  in 
financial  centers.  This  is  caused  by  the  great 
diminution  of  business  activity  which  renders 
unnecessary  a  large  part  of  the  circulating 
medium  that  was  formerly  required  to  transact 
the  greater  volume  of  business.  To  the  extent 
to  which  this  accumulation  of  money  merely  re- 
flects a  redundancy  of  currency  as  distinguished 
from  real  liquid  capital,  it  can  have  little  effect 


MOVEMENTS   OF   SECURITIES   115 

in  encouraging  the  resumption  of  business 
activity.  As  time  passes,  however,  and  econo- 
mies in  operation  commence  to  make  themselves 
manifest,  and  especially  as  waste  and  extrava- 
gance are  curtailed,  the  country  as  a  whole 
commences  to  accumulate  real  liquid  capital; 
that  is  to  say,  its  total  production  leaves  a  sur- 
plus over  the  amount  of  consumption.  In  the 
state  of  business  feeling  which  has  been  pic- 
tured, the  undertaking  of  new  business  ven- 
tures or  additions  to  existing  properties  would 
not  be  approved,  so  that  the  surplus  wealth 
created  finds  its  way  into  bank  deposits  as 
liquid  capital.  The  competitive  attempt  to  loan 
this  capital  at  a  time  when  borrowers  are  few 
produces  merely  nominal  interest  rates.  This 
continues  for  some  time.  It  is  only  gradually 
as  confidence  returns  and  as  the  spirit  of  initia- 
tive begins  to  reassert  itself  that  some  part  of 
the  liquid  capital  created  each  year  is  diverted 
into  fixt  forms.  Here  and  there  some  enter- 
prising group  of  men  will  develop  a  mine,  lay 
a  new  piece  of  railway,  or  make  some  addition 
to  an  existing  undertaking.  For  some  length 
of  time,  however,  the  liquid  capital  of  the  coun- 
try not  only  remains  unimpaired,  but  is  contin- 


n6     HOW   TO    INVEST   MONEY 

ually  increasing.  After  a  time  a  change  comes. 
The  annual  surplus  of  production,  tho  larger 
than  before,  is  only  sufficient  to  provide  for  the 
new  undertakings  which  the  growing  optimism 
demands.  Interest  rates  rise  moderately  in  re- 
sponse to  the  added  demand  for  capital.  A  few 
years  further  along,  as  business  activity  in- 
creases and  success  appears  plainly  to  wait  upon 
new  ventures,  the  demand  for  new  capital  with 
which  to  develop  increased  facilities  and  new 
enterprises  exceeds  the  annual  supply  of  wealth 
created.  Prosperity  having  increased,  another 
factor  commences  to  assert  itself.  The  spirit  of 
economy  and  thrift  which  had  prevailed 
throughout  the  years  of  depression  gives  place 
to  extravagance,  the  demand  for  luxuries,  and 
other  unproductive  forms  of  expenditure. 
While  the  total  production  is  much  greater  than 
in  the  lean  years,  the  margin  of  production  is 
not  proportionately  as  great,  and  this  amount 
is  insufficient  to  meet  the  demands  upon  it.  The 
supplies  of  liquid  capital  stored  up  during  the 
years  of  depression  are  resorted  to,  and  they 
serve  to  provide  the  new  capital  for  a  few  addi- 
tional years.  Interest  rates  at  once  reflect  the 
encroachment  upon  stored-up  capital,  and  their 


MOVEMENTS    OF    SECURITIES    117 

rise  gives  the  first  real  warning  of  the  country's 
true  position.  The  optimistic  business  men  do 
not  heed  the  warning.  After  exhausting  all  the 
real  capital  available  in  the  country,  they  pro- 
ceed to  borrow  extensively  from  foreigners  or 
from  government  banks — in  this  country  from 
the  national  government  through  bank  deposits. 
Every  step  which  can  be  taken  to  induce  for- 
eigners to  part  with  their  capital  is  resorted  to. 
If  foreigners  will  not  buy  long-term  bonds, 
short-term  notes  are  created.  If  the  foreigners 
refuse  these,  they  are  asked  to  make  loans  se- 
cured by  the  new  bonds  and  notes.  The  rates 
of  interest  offered  are  so  attractive  that  consid- 
erable sums  are  usually  obtained,  and  the  pres- 
sure of  business  activity  continues  further. 
Finally  the  day  of  reckoning  arrives  when  some 
incident,  usually  unimportant  in  itself,  first  sug- 
gests to  the  lenders  of  money  that  their  debtors 
whom  they  know  to  be  overextended  may  not 
be  able  to  pay  their  loans.  The  attempt  to  col- 
lect their  loans  produces  a  financial  crisis  which 
brings  to  an  end  the  period  of  prosperity. 

The  foregoing  is  a  description  of  the  more 
important  stages  through  which  business  con- 
ditions pass  from  crisis  to  crisis.  Different 


ii8     HOW   TO    INVEST   MONEY 

cycles  vary  in  particular  details,  but  all  agree 
in  essential  outlines.  Sometimes  special  in- 
fluences are  at  work  which  operate  to  shorten 
or  prolong  the  cycle.  The  approach  of  a  crisis 
will  be  retarded  by  inflation  of  the  currency, 
for  the  excess  finds  its  way  into  bank  vaults  and 
increases  the  volume  of  loanable  credit.  The 
effect  of  such  inflation,  however,  is  wholly 
disastrous,  because  the  addition  to  the  supply  of 
capital  is  fictitious,  not  real,  and  only  defers 
the  day  of  reckoning  for  a  greater  catastrophe. 
On  the  other  hand,  the  approach  of  a  crisis  can 
be  greatly  hastened  by  wars,  conflagrations, 
and  other  agencies  which  destroy  capital,  and 
by  attacks  upon  capital  and  the  conduct  of  cor- 
porate business,  for  such  attacks  tend  to  render 
capital  timid  and  produce  the  same  effect  as  a 
violent  curtailment  of  the  supply.  These  are 
only  some  of  the  many  influences  which  might 
become  operative,  but  they  serve  to  show  the 
necessity  for  careful  consideration  of  all  the 
factors  at  work  if  a  true  conception  of  the  con- 
dition and  tendencies  of  business  is  to  be 
formed. 

From  the  general  account  given  above  of  the 
successive  phases  of  a  credit  cycle,  it  is  possible 


MOVEMENTS   OF   SECURITIES   119 

to  summarize  the  course  of  interest  rates  and 
the  course  of  business  conditions.  Money  rates 
become  suddenly  easy  after  a  crisis,  remain  low 
or  grow  easier  for  a  period  of  several  years,  and 
then  rise  continuously  until  the  next  crisis,  ad- 
vancing with  great  rapidity  toward  the  close  of 
the  cycle.  Business  conditions  remain  poor  or 
grow  worse  a  few  years  after  a  crisis.  Liqui- 
dation is  taking  place,  prices  are  going  down, 
and  the  uncertainty  of  the  outlook  causes  di- 
minished activity.  Thereafter,  however,  con- 
ditions improve  and  activity  increases  with  fair 
uniformity  until  it  reaches  the  high  tension  of 
the  period  immediately  preceding  the  crisis. 
The  course  of  interest  rates  and  the  course  of 
business  conditions  may  both  be  deflected  by 
the  operation  of  special  influences,  but  the  gen- 
eral tendencies  are  substantially  as  outlined. 
The  result  of  the  operation  of  these  joint  fac- 
tors may  be  traced  in  the  market  movements 
of  any  class  of  security  desired.  For  the  sake 
of  simplicity,  let  us  consider  their  effect  in  pro- 
ducing the  market  swings  of  the  highest  grade 
of  investment  issues  and  of  the  lowest  grade, 
those  which  are  affected  only  by  money  rates 
and  those  which  are  affected  almost  wholly  by 
business  conditions. 


120     HOW   TO    INVEST    MONEY 

Emerging  from  the  strain  of  the  crisis  at 
their  lowest  point,  high-grade  bonds,  such  as 
the  best  municipal  and  railroad  issues,  advance 
rapidly  as  interest  rates  decline,  continuing 
their  advancing  tendency  throughout  the  period 
of  business  depression  which  follows  upon  the 
heels  of  the  crisis.  As  business  conditions  im- 
prove, "their  position,  while  perfectly  secure  be- 
fore, is  further  strengthened  and  an  added  stim- 
ulus is  given  to  their  rise.  About  the  middle 
of  the  cycle  when  the  business  outlook  is  very 
promising,  and  before  interest  rates  have  sus- 
tained any  material  advance,  the  prices  of  high- 
grade  bonds  are  usually  at  their  highest  point. 
From  that  time  forward  they  commence  to  de- 
cline, in  spite  of  the  increasing  prosperity  of 
the  country,  under  the  influence  of  rising  money 
rates.  They  make  their  lowest  prices  in  the 
midst  of  the  crisis,  when  the  strain  upon  capital 
is  greatest  and  the  outlook  for  business  most 
unpromising. 

The  lowest  grade  of  bonds,  on  the  other  hand 
(whose  margin  of  security  is  least),  do  not 
commence  to  recover  materially  in  price,  in 
spite  of  the  influence  of  low  money  rates  dur- 
ing the  hard  times  which  follow  the  crisis,  the 


MOVEMENTS    OF    SECURITIES     121 

influence  of  reduced  earnings  and  the  fear  of 
default  of  interest  holding  them  in  check.  As 
the  outlook  becomes  brighter,  they  advance  rap- 
idly and  continue  to  improve  in  price  so  long 
as  they  yield  more  than  current  money  rates. 
At  some  point,  difficult  to  determine  in  advance 
but  usually  well  along  toward  the  end  of  the 
cycle,  they  reach  their  high  point  and  thereafter 
decline  under  the  influence  of  the  growing 
stringency  in  money. 

Between  these  two  extremes,  every  class  of 
security  is  to  be  found.  The  better  ones  will 
tend  to  resemble,  in  their  market  movements, 
the  course  pursued  by  the  choicest  bonds;  the 
poorer  ones  will  approximate  the  lowest  class. 
In  every  case,  however,  unless  special  influences 
operate  to  produce  variations,  the  market  swing 
of  a  given  security  should  be  easily  conjectured 
by  an  investor  who  gives  careful  attention  to 
the  relative  weight  which  is  likely  to  attach  to 
each  determining  influence. 


UNIVERSITY  OF  CALIFORNIA  LIBRARY 
BERKELEY 


Return  to  desk  from  which  borrowed. 
This  book  is  DUE  on  the  last  date  stamped  below. 


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